CourseCourseQ BankQuestion BankDocsDocuments

11.1 Policies to correct disequilibrium in the balance of payments

Syllabus
9708–2026–2027
Topic
11.1
Level
A2

The balance of payments separates current, capital and financial flows

The balance of payments records transactions during a period between residents of an economy and the rest of the world. Receipts/exports of value are generally credits; payments/imports are debits.

Account Main contents Example
Current Goods, services, primary income (interest, profits, dividends, compensation) and secondary income/current transfers such as remittances or current aid Export of services is a credit; dividend paid to an overseas owner is a debit
Capital Capital transfers and acquisition/disposal of non-produced, non-financial assets Debt forgiveness or transfer of ownership rights to certain intangible assets
Financial Direct investment, portfolio investment, other investment and reserve assets A foreign firm buys a domestic company: financial-account inflow/credit under the stated convention

If a resident buys shares in a foreign firm, the asset purchase is a financial-account outflow. Later dividends received from those shares are current-account primary-income credits. The asset and its income therefore belong to different accounts.

A current-account deficit must be financed by net capital/financial inflows, reserve use or an accounting discrepancy. Double-entry accounting makes the full BOP balance in principle, but an individual account can show a persistent imbalance and financing can be unsustainable.

The terms of trade is an index, not a transaction. The trade balance is only part of the current account, and 'the BOP balances' does not mean the current account equals zero or the economy is healthy.

Correct balance-of-payments disequilibrium by targeting its cause

A BOP policy should identify which account is imbalanced, whether the cause is excess income, weak competitiveness, a misaligned exchange rate or financial flows, and whether the position is temporary, structural or unsustainable.

Required policy Main BOP route for a current-account deficit Effectiveness and wider costs
Fiscal Higher taxes/lower spending reduce AD, income and imports; supply-oriented public spending can raise competitiveness later Multiplier and marginal propensity to import; unemployment/growth loss versus long-run capacity
Monetary Higher rates/less credit reduce import demand and may attract financial inflows/appreciation Interest sensitivity, confidence, fixed/floating regime; appreciation can make exports less competitive
Supply-side Productivity, infrastructure, competition and fewer harmful regulations lower unit costs/raise export capacity Long lag, fiscal cost and whether foreign demand/domestic firms respond
Protectionist Tariffs/quotas switch spending away from imports; export support may raise receipts Import PED, domestic supply, consumer/input prices, retaliation, WTO constraints and welfare loss
Exchange-rate Depreciation/devaluation makes exports cheaper and imports dearer in foreign/domestic currency terms Marshall-Lerner, J-curve, spare capacity, imported inflation and foreign-currency debt

For an unwanted current-account surplus, reverse the relevant pressure: appreciation, lower trade barriers/export support, or expansionary demand policy can raise imports/reduce net exports. The choice still depends on inflation, capacity and the reason the surplus exists.

With a fixed exchange rate, a domestic interest-rate rise can reduce imports and attract capital, improving current and financial accounts; under a float the resulting appreciation may later weaken exports. The same instrument therefore has account and regime-specific effects.

Financing a deficit with FDI is not the same as correcting its current-account cause. Improving the current account by recession is also not cost-free success; compare inflation, employment, growth, distribution and sustainability.

Switching changes where spending goes; reducing changes how much is spent

Approach Meaning Deficit instruments and route Main strengths and costs
Expenditure-switching Change the composition of spending between foreign and domestic output Depreciation/devaluation, tariffs/quotas, export subsidies and competitiveness-oriented supply measures raise relative demand for domestic output/exports Can target external demand without deliberately shrinking all AD; depends on elasticities/capacity and risks imported inflation, distortion and retaliation
Expenditure-reducing (dampening) Lower total domestic expenditure/AD Higher direct taxes, lower government spending, higher interest rates or lower money/credit reduce incomes and imports; weak home demand may release output for export Works when import demand is income-sensitive/high marginal propensity to import; costs output, jobs and confidence and may not fix structural competitiveness

For a current-account surplus, switching measures can be reversed by removing export subsidies/protection or allowing appreciation; reducing policy is generally the wrong direction if the aim is to increase imports, while expansionary demand can reduce the surplus by raising import spending.

Choose by cause and parameters. Switching is stronger when export/import demand responds to relative prices and domestic supply can expand. Reducing is relatively stronger when price elasticities are low but the marginal propensity to import is high. Persistent structural deficits often need supply-side improvement; overheating deficits may respond faster to demand restraint.

A tariff raises the relative price of imports and switches some demand to domestic goods. A rise in income tax lowers disposable income and spending on both domestic and imported goods. Both may reduce imports, but only the first is classified by changing relative choice.

A depreciation is switching, not reducing. A recession-driven import fall shows lower expenditure, not improved competitiveness. A policy mix can use both routes, but evaluation must count unemployment, inflation, consumer choice, retaliation and time.