What is the balance of payments (BoP)?
Balance of payments (BoP) = a record of all economic transactions between a country and the rest of the world over a period of time.
Uses double-entry accounting: every transaction is recorded twice.
Credit item = money entering the country.
Debit item = money leaving the country.
A surplus on an account means credits > debits.
A deficit on an account means debits > credits.
In principle, the overall BoP should balance to zero because every credit is matched by a debit.
This diagram shows the current account and the capital/financial account as matching sides of the balance of payments. It is useful for revising why the overall BoP sums to zero. It also reinforces the idea that a current account deficit must be financed elsewhere in the accounts. Source
Main components of the BoP
Current account
Balance of trade in goods
Balance of trade in services
Income
Current transfers
Capital account
Capital transfers
Transactions in non-produced, non-financial assets
Financial account
Foreign direct investment (FDI)
Portfolio investment
Reserve assets
Official borrowing
Exam focus: know which items belong in which account.
This image breaks the current account into goods, services, income and transfers. It is especially helpful for exam questions asking students to classify balance of payments entries correctly. The simple layout makes it easy to memorise the structure of the account. Source
Current account
Measures flows linked to trade and income/current transfers.
Goods balance = value of exports of goods − imports of goods.
Services balance = value of exports of services − imports of services.
Income includes flows such as interest, profits, dividends and wages.
Current transfers include one-way transfers such as aid, remittances and similar transfers.
A current account surplus means the country is earning more from these flows than it is paying out.
A current account deficit means the country is paying out more than it earns from these flows.
Common exam trap: balance of trade is only goods in the syllabus wording here; do not confuse it with the broader current account.
Capital account
Usually the smallest account in exam questions.
Includes capital transfers.
Includes transactions in non-produced, non-financial assets.
In exams, students often only need to identify these items correctly rather than discuss them in depth.
Financial account
Records transactions involving financial assets and liabilities.
FDI = long-term investment involving a lasting interest/control in firms abroad.
Portfolio investment = purchase/sale of shares and bonds without control.
Reserve assets = changes in a central bank’s foreign currency reserves.
Official borrowing = borrowing by the government/public sector from abroad.
Key idea: a country with a current account deficit must generally finance it through a financial account surplus and/or reserve changes.
This diagram shows how the capital account and financial account are built up from their main sub-components. It is useful for distinguishing FDI, portfolio flows, and other financial movements from current account items. Students can use it to practise classification questions quickly. Source
Credits, debits and interpreting entries
Credit entries are inflows of money, for example:
exports of goods and services
income receipts from abroad
capital inflows such as foreign investment into the country
Debit entries are outflows of money, for example:
imports of goods and services
income payments to abroad
capital outflows such as domestic purchase of foreign assets
Exam skill: be able to decide whether a transaction is a credit or debit and identify the correct account.
Interdependence between the accounts
The BoP has a zero balance overall.
Credits are matched by debits.
Therefore, deficits are matched by surpluses elsewhere in the accounts.
A current account deficit is typically matched by a capital/financial account surplus.
A current account surplus is typically matched by a capital/financial account deficit.
This is a core explanation point in 10-mark and 15-mark responses.
HL only: Current account and the exchange rate
There is a relationship between the current account and the exchange rate.
A depreciation/devaluation can improve the current account by making exports cheaper and imports more expensive.
An appreciation/revaluation can worsen the current account by making exports more expensive and imports cheaper.
However, the effect is not automatic and depends on price elasticities of demand for exports and imports.
In diagram questions, explain the link through changes in export demand and import expenditure.
HL only: Financial account and the exchange rate
There is also a relationship between the financial account and the exchange rate.
Higher demand for domestic financial assets can increase capital inflows.
Greater capital inflows increase demand for the currency, tending to cause appreciation.
Capital outflows increase supply of the currency on foreign exchange markets, tending to cause depreciation.
Strong answers link investor confidence, interest rates, and capital flows.
HL only: Persistent current account deficit — implications
May put downward pressure on the exchange rate.
May lead to higher interest rates if policymakers try to attract capital inflows or defend the currency.
Can increase foreign ownership of domestic assets.
Can raise external debt over time.
May weaken credit ratings if investors fear repayment problems.
Can constrain demand management policy.
May reduce long-run economic growth if the deficit reflects weak competitiveness.
Evaluation point: a persistent deficit is not always bad if it finances productive investment.
HL only: Correcting a persistent current account deficit
Expenditure switching policies
Aim to switch spending from imports to domestic goods/services.
Example: depreciation/devaluation, protectionist policies.
Expenditure reducing policies
Aim to reduce total spending in the economy so imports fall.
Example: contractionary fiscal policy or contractionary monetary policy.
Supply-side policies
Improve international competitiveness.
Example: better productivity, infrastructure, education/training.
Evaluation should consider time lags, side effects, conflicts with other macro objectives, and whether the deficit is caused by structural or cyclical factors.
HL only: Marshall–Lerner condition
A depreciation/devaluation will improve the current account only if the sum of the price elasticities of demand for exports and imports is greater than 1.
If demand is too inelastic, the value of imports may rise and export revenue may not increase enough.
This is why a weaker currency does not always solve a current account deficit.
Exam tip: define the condition clearly, then apply it to export and import elasticities.
HL only: J-curve effect
After a depreciation/devaluation, the current account may worsen first before it improves later.
In the short run, demand for imports and exports is often price inelastic.
Contracts, habits and time needed to switch suppliers mean quantities adjust slowly.
So import spending may initially rise, worsening the current account deficit.
In the long run, quantities adjust more, so the current account may improve if the Marshall–Lerner condition holds.
This diagram illustrates the J-curve effect: after a depreciation, the current account can initially worsen before later improving. It is useful for explaining the time lag between a change in the exchange rate and the response of export and import quantities. The graph also helps students connect the idea to the Marshall–Lerner condition. Source
How to answer exam questions well
Start by defining BoP, credit, debit, surplus or deficit precisely.
Classify items carefully into current, capital, or financial account.
When explaining imbalances, always refer to the fact that the overall BoP balances.
For HL evaluation, distinguish between short-run and long-run effects.
Use phrases such as persistent current account deficit, competitiveness, capital inflows, exchange rate pressure, and policy effectiveness.
Checklist: can you do this?
Identify whether a transaction is a credit or a debit.
Classify transactions into the current, capital, or financial account.
Explain why the overall BoP must balance to zero.
Analyse how a depreciation/devaluation may affect the current account.
Evaluate policies to correct a persistent current account deficit (HL only).
Common mistakes to avoid
Confusing the current account with the balance of trade in goods only.
Forgetting that the overall BoP balances, even if one account is in deficit.
Mixing up FDI and portfolio investment.
Assuming depreciation will always improve the current account.
Ignoring time lags and elasticities in HL essays.
Dave is a Cambridge Economics graduate with over 8 years of tutoring expertise in Economics & Business Studies. He crafts resources for A-Level, IB, & GCSE and excels at enhancing students' understanding & confidence in these subjects.
Dave is a Cambridge Economics graduate with over 8 years of tutoring expertise in Economics & Business Studies. He crafts resources for A-Level, IB, & GCSE and excels at enhancing students' understanding & confidence in these subjects.