Cambridge Syllabus Notes

Government Macro‑economic Intervention – Balance of Payments (BoP) Stability

1. What is the Balance of Payments?

The Balance of Payments records all economic transactions between residents of a country and the rest of the world over a set period (normally one year). It is compiled in three accounts that must balance overall:

Current Account
Capital Account
Financial Account

2. Structure of the Balance of Payments

2.1 Current Account

The current account measures the flow of goods, services, income and transfers. It has four sub‑components:

Trade in Goods (Merchandise) – exports (X) and imports (M) of physical products.
Trade in Services – tourism, transport, insurance, consulting, etc.
Primary (Factor) Income – net earnings on investments and wages earned abroad (inflows – outflows). Example: dividend receipts from overseas firms (£5 bn) minus interest payments to foreign lenders (£3 bn) = +£2 bn.
Secondary (Transfer) Income – unilateral transfers such as remittances, foreign aid and gifts.

Current‑account balance formula:

    Current‑account balance = (X − M) + Net Primary Income + Net Secondary Transfers

Worked example (all figures in £ bn):

Item	Value
Exports of goods (X)	200
Imports of goods (M)	250
Net primary income	+10
Net secondary transfers	‑5
Current‑account balance	‑45 bn (deficit)

2.1.1 Causes of a Current‑account Deficit

High domestic demand for imported goods and services.
Poor export competitiveness (high production costs, weak overseas demand).
Unfavourable terms of trade (price of imports rises faster than price of exports).
Large outflows of primary income (e.g., high interest payments on foreign debt).

2.1.2 Causes of a Current‑account Surplus

Strong export performance or high world prices for domestic commodities.
Low domestic demand for imports (e.g., high savings rate).
Positive net primary income (large foreign investment returns).
Significant inflows of secondary transfers (e.g., remittances).

2.1.3 Consequences of Persistent Deficits or Surpluses

Deficit – depletion of foreign‑exchange reserves, pressure for currency depreciation, higher import‑price inflation, possible need for external borrowing, and reduced investor confidence.
Surplus – accumulation of reserves, upward pressure on the exchange rate (possible loss of export competitiveness), and potential “over‑heating” of the economy if the surplus reflects excessive saving.

2.2 Capital Account (IGCSE focus)

In the IGCSE syllabus the capital account is relatively small. It records:

Transfers of non‑produced, non‑financial assets (e.g., debt forgiveness, sale/purchase of patents, copyrights, trademarks).
International aid for capital formation (e.g., infrastructure grants).

2.3 Financial Account – brief overview

Although detailed financial‑account analysis is not required for IGCSE, a short description helps students understand the overall BoP picture.

Direct Investment – acquisition of a lasting interest (≥10 % voting power) in an overseas enterprise.
Portfolio Investment – purchase of stocks, bonds or other securities without control.
Other Investment – loans, currency deposits, trade credit, etc.
Official‑reserve transactions – buying or selling foreign currency, gold or IMF positions by the central bank.

3. Why Governments Seek BoP Stability

Prevents excessive currency depreciation (which can fuel inflation) or appreciation (which can hurt exporters).
Maintains confidence of foreign investors, lenders and trading partners.
Protects employment in export‑oriented sectors and avoids sudden job losses.
Reduces the need for emergency borrowing or rapid depletion of foreign‑exchange reserves.

4. Policy Instruments for Achieving BoP Stability

Policy Tool	Targeted BoP Component	Typical Effect on BoP	Potential Side‑effects
Exchange‑rate Intervention (buying/selling foreign reserves)	Overall BoP (via changes in official reserves)	Selling reserves → currency depreciation → exports become cheaper → trade balance improves. Buying reserves → currency appreciation → imports become cheaper → trade balance improves.	May deplete reserves; depreciation can raise import‑price inflation; appreciation can hurt export‑oriented firms.
Tariffs and Import Quotas	Current Account – Trade in Goods	Reduces import volume → improves trade balance.	Higher consumer prices; risk of retaliation; possible WTO disputes.
Export Subsidies	Current Account – Trade in Goods/Services	Boosts export volumes → improves trade balance.	Fiscal cost; may breach WTO rules; can provoke “subsidy wars”.
Capital Controls (taxes, limits or bans on certain capital flows)	Financial Account	Restricts capital outflows or speculative inflows → narrows financial‑account deficit/surplus.	Can deter foreign direct investment; may create black‑market activity.
Monetary Policy – Interest‑rate changes	Financial Account (portfolio flows) & Current Account (through exchange‑rate impact)	Higher rates attract foreign capital → improve financial account; currency appreciation may reduce export competitiveness.	Higher rates can slow domestic growth, raise unemployment and increase borrowing costs.
Fiscal Policy – Government spending & taxation	Current Account (via domestic demand for imports)	Reducing public spending or raising taxes lowers import demand → improves trade balance.	Deep cuts may increase unemployment and reduce welfare; expansionary policy can worsen a deficit.

4.1 Evaluation of Policy Effectiveness

When assessing a tool, consider:

Speed of impact – how quickly the measure influences the BoP.
Durability – whether the effect can be sustained without severe side‑effects.
Feasibility – availability of reserves, compliance with WTO/IMF rules, and political acceptability.

Tool	Short‑run Effectiveness	Long‑run Sustainability	Key Constraints
Tariffs / Quotas	Very quick – import volume falls immediately.	Limited – may provoke retaliation, reduce welfare, and damage export sectors.	WTO rules; domestic price rises.
Export Subsidies	Quick boost to export volumes.	Often unsustainable – fiscal burden and potential WTO sanctions.	Budgetary cost; international rules.
Exchange‑rate Intervention	Effective if sufficient reserves are available.	Depends on reserve adequacy; can become costly if market pressure persists.	Reserve levels; credibility of the peg.
Capital Controls	Immediate restriction of volatile flows.	May discourage long‑term investment; can be circumvented.	Investor confidence; potential illicit markets.
Monetary Policy (interest rates)	Moderate – capital flows respond within months.	Can be maintained but may conflict with domestic growth objectives.	Trade‑off between inflation, growth and BoP.
Fiscal Adjustment	Slow – changes in consumption and import demand take time.	More sustainable if structural reforms accompany cuts.	Political resistance; impact on public services.

5. Exchange‑rate Regimes and Their Influence on BoP Stability

Regime	Key Features	Effect on BoP Stability	Major Drawbacks
Fixed (Pegged) Exchange Rate	Government commits to a set parity; defends it by buying/selling reserves.	High short‑run BoP stability – any deficit/surplus is absorbed by reserve flows.	Requires large reserve holdings; loss of monetary‑policy autonomy; vulnerable to speculative attacks.
Managed Float (Dirty Float)	Central bank intervenes occasionally to keep the rate within a target band.	Provides moderate stability while retaining some policy flexibility.	Intervention costs; timing can be uncertain; may still allow occasional volatility.
Floating Exchange Rate	Rate determined entirely by market forces.	Automatic adjustment: a deficit tends to depreciate the currency, improving the trade balance.	Can be volatile, creating uncertainty for traders and investors; may lead to large short‑run swings.

Suggested diagram: “Managed Float – Central Bank Intervention”. Show a market‑determined exchange‑rate curve, a target band, and arrows indicating when the bank buys (to support) or sells (to weaken) foreign reserves.

6. Summarising Evaluation Points for Exams

Define the Balance of Payments and list its three main accounts.
Identify the four sub‑components of the current account and explain that primary income is a net figure.
Write the current‑account balance formula and solve a simple numeric example.
State the main causes of a current‑account deficit and surplus, and outline their likely macro‑economic consequences (inflation, reserve changes, exchange‑rate pressure, employment).
Describe at least three government policy tools, the BoP component they target, the expected effect, and one key side‑effect.
Compare fixed, managed‑float and floating exchange‑rate regimes specifically in terms of BoP stability, noting advantages and disadvantages.
Evaluate which tools are most appropriate in the short run versus the long run, considering feasibility, external constraints (WTO, IMF) and trade‑offs such as inflation, unemployment and foreign‑investment attractiveness.

The macroeconomic aims of government: balance of payments stability