The range of policies available to achieve balance of payments stability and their effectiveness

Cambridge IGCSE / A‑Level Economics – Complete Syllabus Notes

Unit 1 – The Basic Economic Problem

1.1 Scarcity, Choice & Opportunity Cost

• Scarcity: Limited resources vs unlimited wants – the fundamental economic problem.
• Three economic questions: What to produce? How to produce? For whom to produce?
• Opportunity cost: The next best alternative foregone when a choice is made.
  

  Example: Choosing to spend £100 on a concert ticket means the opportunity cost is the holiday that could have been bought with the same money.

1.2 Factors of Production & Rewards

1.3 Production Possibility Curve (PPC)

• Definition: Shows the maximum output combinations of two goods that an economy can produce with existing resources and technology.
• Key features:

  • Efficient points – on the curve.
  • Inefficient points – inside the curve.
  • Unattainable points – outside the curve.

• Shifts:

  • Outward shift – economic growth (more resources, better technology).
  • Inward shift – recession, natural disaster, war.

• Opportunity cost on the PPC is represented by the slope (marginal rate of transformation).

Unit 2 – Allocation of Resources (Micro‑economics)

2.1 Demand and Supply

• Law of demand: Inverse relationship between price and quantity demanded (ceteris paribus).
• Law of supply: Direct relationship between price and quantity supplied.
• Equilibrium: Intersection of demand and supply curves – determines market price and quantity.
• Shifts:

  • Demand ↑: higher income, tastes, population, price of substitutes, expectations.
  • Supply ↑: lower input costs, technology improvement, more firms, subsidies.

2.2 Price Elasticities

2.3 Market Failure & Government Intervention

• Public goods: Non‑rival, non‑excludable (e.g., street lighting). Market under‑provides → government provision.
• Externalities:

  • Negative (pollution) – impose taxes, regulation.
  • Positive (vaccination) – subsidies, provision.

• Merit & demerit goods: Merit – under‑consumed, government subsidises; Demerit – over‑consumed, government taxes or bans.
• Information failure: Asymmetric information leads to market inefficiency (e.g., used‑car market).
• Government tools:

  • Taxes (excise, ad valorem) – reduce consumption of demerit goods.
  • Subsidies – encourage merit goods.
  • Price controls: price ceiling (e.g., rent control) & price floor (minimum wage).
  • Regulation & standards.

Unit 3 – Microeconomic Decision‑Makers

3.1 Households

• Decisions based on income, preferences, prices, expectations.
• Three‑sector model: C (consumption), S (saving), B (borrowing).
  

  Identity: Income = C + S – B (or C = Income – S + B).

• Impact of interest rates: Higher rates encourage saving, discourage borrowing.

3.2 Firms

• Cost curves – TC, AFC, AVC, ATC, MC. MC cuts ATC at the minimum point (efficient scale).
• Revenue – TR = P × Q. MR = ΔTR/ΔQ.
• Profit maximisation where MR = MC (in competitive markets) or where MC = MR and P > ATC (monopoly).
• Market structures:

  • Perfect competition – many sellers, homogeneous product, price taker.
  • Monopoly – single seller, price maker, barriers to entry.
  • Monopolistic competition – many sellers, differentiated products.
  • Oligopoly – few large firms, strategic interaction.

3.3 Labour Market

• Demand for labour derived from marginal product of labour (MPL); supply from workers’ willingness to work at different wages.
• Equilibrium wage and employment determined by intersection of labour demand and supply.
• Minimum wage (price floor) – can create unemployment if set above equilibrium.

3.4 Money & Banking

• Functions of money: Medium of exchange, unit of account, store of value, standard of deferred payment.
• Central bank (e.g., Bank of England, Federal Reserve):

  • Issues currency, controls money supply, acts as lender of last resort.
  • Implements monetary policy (interest rates, open‑market operations, reserve requirements).

• Commercial banks create money through fractional‑reserve banking:
  

  Money multiplier = 1 / reserve ratio.

Unit 4 – Government & the Macro‑economy

4.1 Fiscal Policy

• Government budget: Revenue (taxes, non‑tax) – Expenditure = Budget balance.

  • Deficit = Expenditure > Revenue.
  • Surplus = Revenue > Expenditure.

• Tools:

  • Taxation – direct (income, corporation) & indirect (VAT, excise).
  • Government spending – on goods & services, transfers.

• Multiplier effect: ΔY = k × ΔG (or ΔT), where k = 1 / (MPC × (1‑t) + MPI).
• Potential side‑effects: crowding‑out, inflationary pressure.

4.2 Monetary Policy

• Instruments:

  • Policy interest rate (repo, base rate).
  • Open‑market operations (buy/sell government securities).
  • Reserve requirements.
  • Quantitative easing (large‑scale asset purchases).

• Transmission mechanisms:

  • Interest‑rate channel → investment & consumption.
  • Exchange‑rate channel → export competitiveness.
  • Asset‑price channel → wealth effect.

• Limitations: liquidity trap, time lags, credibility issues.

4.3 Supply‑Side Policies

• Goal: increase LRAS (potential output) without generating inflation.
• Measures:

  • Improving education & training.
  • Investing in infrastructure.
  • Reducing regulation & bureaucracy.
  • Tax incentives for R&D and investment.

4.4 Macro‑economic Objectives & Indicators

Unit 5 – Economic Development

5.1 Measuring Development

• GDP per capita – average income, but ignores distribution and non‑market activities.
• Human Development Index (HDI) – combines life expectancy, education, and GNI per capita.
• Multidimensional Poverty Index (MPI) – health, education, living standards.

5.2 Causes of Under‑development

• Low levels of human capital, poor infrastructure, weak institutions, limited access to finance, political instability, unfavourable geography.

5.3 Strategies for Development

• Export‑led growth – promote comparative advantage, special economic zones.
• Import‑substitution industrialisation (ISI) – protect infant industries, develop domestic manufacturing.
• Foreign Direct Investment (FDI) – attract capital, technology transfer, job creation.
• Aid & Debt Relief – concessional loans, grants, debt‑swap programmes.
• Sustainable development – green technologies, renewable energy, inclusive policies.

5.4 Role of International Organisations

• World Bank, IMF – provide financing, policy advice, conditionality.
• UNDP, WTO – support development projects, trade liberalisation.

Unit 6 – International Trade & Globalisation – Balance of Payments (BoP)

6.1 What is the Balance of Payments?

The BoP records all economic transactions between residents of a country and the rest of the world over a period (usually a year). It consists of three main accounts:

• Current Account – trade in goods & services, primary income, secondary income.
• Capital Account – capital transfers (e.g., debt forgiveness).
• Financial Account – direct investment, portfolio investment, other investment, reserve assets.

By definition, the BoP always balances (including the statistical discrepancy).

6.2 Current‑Account Components

6.3 Calculating the Current‑Account Balance

where X = exports of goods & services, M = imports of goods & services.

6.4 Worked Example

6.5 Why Do Deficits or Surpluses Occur?

• Deficits – high domestic demand for imports, weak export competitiveness, large outflows of primary income (interest on foreign debt), net outflows of secondary transfers.
• Surpluses – strong export sector (comparative advantage, favourable exchange rate), low import demand, net inflows of primary income, net inflows of secondary transfers.

6.6 Policies to Achieve BoP Stability

6.6.1 Exchange‑Rate Policy

• Fixed (Pegged) Rate – Central bank buys/sells foreign currency to keep the rate at a predetermined level.
• Managed Float (Dirty Float) – Occasional intervention to smooth excessive volatility.
• Floating Rate – Determined by market forces; can correct imbalances automatically.

Effectiveness: A devaluation under a fixed or managed system makes imports more expensive and exports cheaper, helping to reduce a deficit. However it requires ample foreign‑exchange reserves and reduces monetary‑policy independence.

6.6.2 Fiscal Policy

• Reduce government spending or raise taxes → lower aggregate demand → less import demand.
• Targeted tax incentives or subsidies for export‑oriented industries.

Effectiveness: Can improve the current account, but the impact is delayed and may cause recessionary pressure if the contraction is large.

6.6.3 Monetary Policy

• Raise interest rates → attract foreign capital, strengthen the currency, lower import demand.
• Lower rates → stimulate investment in export sectors (though may weaken the currency).

Effectiveness: Influences exchange rates and capital flows, but the transmission to the current account can be weak when exchange‑rate pass‑through is low.

6.6.4 Trade Policy

• Tariffs & import quotas – Directly reduce import volumes.
• Export subsidies – Lower producers’ costs, raise export volumes.
• Trade agreements – Improve market access for domestic exporters.

Effectiveness: Tariffs can improve the current account in the short run but may provoke retaliation, raise consumer prices and breach WTO rules.

6.6.5 Capital Controls

• Limits on short‑term capital inflows/outflows, foreign‑currency borrowing caps.

Effectiveness: Can prevent sudden capital flight and protect the current account, but may deter beneficial foreign investment and are difficult to enforce in a highly integrated global market.

6.6.6 Structural Reforms

• Improve productivity and competitiveness of export sectors (e.g., skills training, R&D incentives).
• Invest in transport, energy and ICT infrastructure.
• Diversify the export base away from import‑dependent commodities.

Effectiveness: Provides a sustainable, long‑term solution; gains appear over several years but create lasting current‑account improvement.

6.7 Comparative Summary of Policies

6.8 Evaluating Policy Effectiveness – Key Considerations

1. Time horizon – Tariffs and devaluations act quickly; structural reforms need years.
2. Economic side‑effects – Impact on inflation, growth, employment, income distribution.
3. External constraints – WTO rules, IMF conditionalities, global market reactions.
4. Policy mix – Combining exchange‑rate adjustment with fiscal tightening often yields a balanced outcome.
5. Country context – Small open economies rely heavily on exchange‑rate policy; larger economies can use a broader toolkit.

6.9 Illustrative Case Study (Brief)

Country A – Persistent Current‑Account Deficit

• Problem: Deficit of 5 % of GDP, driven by high import demand for oil and low export diversification.
• Policy mix adopted:

  • Devalued the currency by 12 % (managed float) – export prices fell, import prices rose.
  • Introduced a temporary import tariff on non‑essential consumer goods (10 %).
  • Implemented a fiscal consolidation package – reduced public‑sector wages by 5 % and postponed non‑critical infrastructure projects.
  • Launched a structural reform programme – subsidies for renewable‑energy R&D and a skills‑training scheme for the textile sector.

• Outcome after 18 months: Current‑account deficit fell to 2 % of GDP; export growth accelerated 4 % YoY; inflation rose modestly (2 %).
• Evaluation: Exchange‑rate move gave the quickest impact; fiscal tightening risked recession but was limited in scope; structural reforms are expected to sustain the improvement.

6.10 Summary

Balance‑of‑payments stability can be pursued through a range of policy instruments. Short‑term tools (exchange‑rate adjustments, tariffs, fiscal tightening) provide rapid correction but may generate adverse side‑effects. Long‑term measures (structural reforms, supply‑side policies) build competitiveness and reduce reliance on temporary fixes. Successful management typically involves a well‑designed mix tailored to the country’s size, openness, and institutional capacity.