Effect of Policies on the Balance of Payments (Cambridge (CIE) A Level Economics): Revision Note

What is most likely to lead to a persistent surplus in a country's current account of its balance of payments?

A. - highly contractionary monetary policy

B. - an undervalued exchange rate

C. - highly protectionist policies by other countries

D. - low investment income from abroad

Answer: B

A persistent current account surplus requires a structural condition that consistently makes exports competitive and suppresses imports over many years - this points to exchange rate policy

An undervalued exchange rate keeps exports artificially cheap for foreign buyers and imports artificially expensive for domestic consumers on a continuous basis - this is the mechanism that underpins persistent surpluses (China's management of the renminbi is the classic example)

Worked solution

• Option A is a trap — contractionary monetary policy raises interest rates, which typically appreciates the exchange rate, making exports dearer and actually worsening the current account, not creating a surplus

• Option C is plausible but wrong — protectionist policies by other countries reduce demand for the country's exports, which would worsen rather than improve its current account

• Option D is incorrect — low investment income from abroad is a debit on primary income in the current account, which would tend to worsen rather than improve the current account balance

A government decides to allow the country's currency to depreciate to remove the deficit on its current account of the balance of payments. What is the most likely reason why this would not work?

A. - the country gains a competitive advantage from the depreciation

B. - the country has a surplus on its capital and financial accounts

C. - the price elasticities of demand for the country's exports and imports are greater than one

D. - there are high trade barriers with the country's main trading partners

Answer: D

Depreciation works by making exports cheaper in foreign currency and imports dearer in domestic currency - this switches expenditure away from imports and towards domestic goods, improving the current account

For this to work, foreign buyers must actually respond by purchasing more of the country's exports - but if high trade barriers exist with trading partners (tariffs, quotas, sanctions), foreign buyers cannot easily access the goods even if they are now cheaper; the price signal is blocked before it can take effect

Worked solution

• Option A is incorrect - gaining competitive advantage is precisely the mechanism by which depreciation should work, not a reason it would fail

• Option B is incorrect - a surplus on the capital and financial accounts is actually what finances the current account deficit; it does not prevent depreciation from correcting the CA

• Option C is the trap - students who partially recall the Marshall-Lerner condition may think PED > 1 causes a problem; in fact the opposite is true: if the sum of PED for exports and imports exceeds one, the M-L condition is satisfied and depreciation will improve the current account; it would only fail if PEDs were less than one

The key examiner trap in this topic is confusing the effect of a policy on the current account with its effect on the financial account — they often move in opposite directions.

Higher interest rates improve the financial account via hot money inflows but worsen the current account via appreciation; always analyse both channels separately and state the net effect as uncertain.

For exchange rate depreciation, never state it improves the current account without conditioning it on the Marshall-Lerner condition being satisfied.

Supply-side policy is the only approach that improves both accounts simultaneously and sustainably — this makes it the strongest evaluative conclusion when asked to compare policies.