Balance of Payments & Exchange Rates

Current account, exchange rate systems, depreciation effects, Marshall-Lerner, J-curve & international competitiveness

SPEC 4.1 • A GLOBAL PERSPECTIVE

Key Definitions

Current Account (BOP)

A record of a country's transactions with the rest of the world including trade in goods, trade in services, primary income and secondary income.

Current Account Deficit

When the value of a country's imports of goods, services and income flows exceeds its exports.

Appreciation

An increase in the value of a currency under a floating exchange rate system (driven by market forces).

Depreciation

A decrease in the value of a currency under a floating exchange rate system.

Exam Tip

Appreciation/depreciation = floating (market forces). Revaluation/devaluation = fixed (government decision). Confusing these terms costs marks every year.

Balance of Payments Structure

AccountComponentsExamples

Current AccountTrade in goods (visible), trade in services (invisible), primary income, secondary incomeCar exports, tourism revenue, dividends from overseas investments, foreign aid

Capital AccountCapital transfers (small)EU structural funds, debt forgiveness

Financial AccountFDI, portfolio investment, reserve assetsToyota building a UK factory, buying US government bonds, Bank of England forex reserves

Golden Rule

The BOP always balances: Current Account + Capital Account + Financial Account = 0. A current account deficit must be financed by a financial account surplus (capital inflows). The UK has run a persistent current account deficit for decades, financed by inward FDI and portfolio investment.

Causes of a Current Account Deficit

5 Key Causes

Overvalued exchange rate → exports priced out of foreign markets, imports cheap

Low international competitiveness → high unit labour costs, high inflation relative to rivals

High domestic income/growth → more imports demanded (income elastic goods)

Structural weakness → low-value-added manufacturing sector, over-reliance on imported goods

Strong domestic demand → consumers spending heavily on foreign-produced goods

Exam Tip

Chain of reasoning: Don't just list causes. Develop: "High domestic income growth → rising disposable income → demand for imported goods rises (especially income-elastic imports like electronics, cars) → value of imports exceeds exports → current account deficit widens."

Correcting a Current Account Deficit

Policy TypeHow It WorksLimitation

Expenditure-SwitchingSwitch spending from imports to domestic goods: depreciation, tariffs, subsidies to exportersDepreciation only works if Marshall-Lerner met; tariffs risk retaliation

Expenditure-ReducingReduce total demand → fewer imports: contractionary fiscal policy, higher interest ratesCauses recession and higher unemployment — politically costly

Supply-SideImprove long-run competitiveness: reduce unit labour costs, invest in R&D, boost productivityVery slow to take effect — may take years before export performance improves

Examiner Alert

A 2024 Paper 2 essay asked students to evaluate macroeconomic policies to reduce a current account deficit. Top answers distinguished clearly between expenditure-switching and expenditure-reducing AND used Marshall-Lerner/J-curve as evaluation. Weak answers just listed policies without developing chains.

Exchange Rate Systems

Floating

Determined entirely by market forces of supply and demand in the forex market. No government intervention. E.g. GBP, USD, EUR. Self-correcting: deficit → depreciation → competitiveness improves.

Fixed

Government/central bank maintains the exchange rate at a specific value by buying/selling forex reserves. E.g. Chinese renminbi historically. Provides certainty but requires large reserves.

Managed (Dirty) Float

Exchange rate floats but the central bank intervenes when the rate moves too far from a target. Combines elements of both systems. Intervention = buying/selling currency in forex market.

Managed ER vs Interest Rates

#1 Examiner Error — October 2020 Paper 3 (Turkey)

This was the most commonly noted error in the October 2020 examiner report. Students confused interest rate policy with exchange rate intervention. These are two separate mechanisms.

Managed ER Intervention (Direct)

Central bank BUYS domestic currency in forex market → demand for currency rises → currency appreciates.

Central bank SELLS domestic currency → supply rises → currency depreciates.

This uses foreign exchange reserves.

Interest Rate Policy (Indirect)

Raise interest rates → hot money flows in (investors seek higher yield) → demand for currency rises → currency appreciates.

This is monetary policy that indirectly affects the exchange rate via capital flows. It is NOT direct forex intervention.

Exam Tip

If a Paper 3 question asks about a managed exchange rate, your answer must reference buying/selling currency in the forex market. If you only discuss interest rate changes, you are answering the wrong question and will score poorly.

6 Factors Determining Floating ER

Learn All 6 — Each is a Chain of Reasoning

Inflation differentials: Higher UK inflation → UK exports less competitive → demand for £ falls → depreciation

Interest rate differentials: Higher UK rates → hot money flows in seeking yield → demand for £ rises → appreciation

Current account position: Persistent deficit → net supply of £ to buy foreign currency → depreciation

Speculation: Traders buy/sell currencies on expected future movements → can cause overshooting

FDI flows: Inward FDI → demand for £ rises → appreciation

Relative economic growth: Faster UK growth → more imports demanded → supply of £ rises → depreciation

Forex Market Diagram

Diagram required — showing how supply and demand for sterling determine the exchange rate.

Reading the Diagram

E.g. UK interest rates rise → hot money inflows → D£ shifts right (D£ → D£') → exchange rate rises from e* to e₁ → pound appreciates. Exports become more expensive, imports cheaper → current account may worsen.

Effects of Depreciation

The examiner expects the full chain across all four impact areas.

Impact AreaChain of Reasoning

Current AccountExports cheaper for foreigners → export volume ↑. Imports dearer for domestic buyers → import volume ↓. IF Marshall-Lerner met → CA improves (long run). J-curve worsening first.

InflationImport prices rise in domestic currency (oil, food, raw materials) → cost-push inflation → SRAS shifts left. MPC may need to raise rates → dampens growth.

Growth & EmploymentStronger exports boost (X-M) → AD shifts right → GDP ↑ and employment ↑. But inflationary pressure from imports partially offsets this benefit.

FDI FlowsUK assets become cheaper for foreign investors → inward FDI may increase. But may signal economic weakness → confidence may fall.

Marshall-Lerner Condition

A depreciation will improve the current account only if the sum of the price elasticities of demand for exports and imports (in absolute value) exceeds 1.

|PEDₓ| + |PED_m| > 1 → Current account IMPROVES

Condition Met (Elastic Demands)

Export and import volumes respond strongly to the price change → total export revenue rises, total import spending falls → CA improves.

Condition NOT Met (Inelastic)

Volumes barely change but import prices rise in domestic currency → total import bill actually increases → CA worsens despite depreciation.

Exam Tip

This is the single most important evaluation point for any exchange rate essay. State the formula, explain the logic, and note that in the short run demands are typically inelastic → ML not met → J-curve.

J-Curve Effect

J-Curve

After a depreciation, the current account initially worsens before improving — because import/export contracts are fixed in the short run and demand is inelastic until contracts expire (12–18 months).

Why the J-Shape?

Short run: Import/export contracts are fixed in foreign currency → volumes don't adjust → import bill rises (paying more per unit) → CA worsens. Long run (12–18 months): Contracts expire, firms and consumers adjust → export volumes rise, import volumes fall → CA improves past original level.

International Competitiveness

Relative Unit Labour Costs

ULC = Wage rate ÷ Labour productivity. If UK wages rise faster than productivity, ULCs rise → UK goods more expensive → less competitive internationally.

Relative Export Prices

Compare UK export price levels to trading partners (often via the Real Effective Exchange Rate — REER). If UK export prices rise relative to competitors → UK loses market share.

Price vs Non-Price Competitiveness

Price factors: Exchange rate, inflation, wage costs relative to productivity.

Non-price factors: Product quality, reliability, technological innovation, branding, after-sales service, design, delivery times. UK comparative advantage is increasingly in services (financial services, higher education, creative industries) where non-price factors dominate.

Competitive Devaluation

Competitive Devaluation / Depreciation

When countries deliberately weaken their currency to gain an export advantage — sometimes called a "currency war" or "beggar-thy-neighbour" policy.

Consequences

Short-term gain: Exports become cheaper → export volume rises → AD boost

Retaliation risk: Trading partners may devalue in response → no one gains, but all suffer higher import costs

Import-push inflation: Dearer imports raise costs → cost-push inflation → living standards fall

Uncertainty: Volatile exchange rates discourage international trade and investment

Exam Tip

If asked about competitive devaluation, link to game theory: each country has an incentive to devalue (dominant strategy), but if all devalue, the outcome is worse for everyone (Prisoner's Dilemma). This is a strong Paper 3 synoptic point.

Significance of Global Trade Imbalances

The spec requires you to evaluate the significance of persistent surpluses and deficits.

Problems of Persistent Deficit

Must be financed by borrowing or selling assets → rising external debt

Downward pressure on exchange rate → imported inflation

May signal structural uncompetitiveness

Loss of domestic jobs in import-competing sectors

Problems of Persistent Surplus

Upward pressure on exchange rate → reduces competitiveness over time

Trading partners face corresponding deficits → global imbalance

May indicate suppressed domestic consumption

Pressure from WTO/IMF for surplus countries to rebalance

Examiner Alert

A November 2021 Paper 2 essay asked students to evaluate the effects of a persistent current account deficit. Top answers discussed both the financing constraint (financial account flows) and the structural implications. Don't assume a deficit is always bad — it may reflect a strong economy attracting imports and FDI.

AO4 Evaluation Toolkit

Use these frames in any essay on exchange rates or the BOP:

5 Evaluation Points

Marshall-Lerner condition: "Depreciation only improves the CA if |PEDx| + |PEDm| > 1. In the short run, demands are inelastic → J-curve worsening. Must specify the time period."

Inflationary impact: "Depreciation raises import prices → cost-push inflation → may worsen living standards and force the MPC to raise interest rates, dampening any growth stimulus."

Non-price factors: "Export demand depends on quality, technology, reliability — not just price. A depreciation does not address structural competitiveness weaknesses."

Confidence effects: "Currency depreciation may signal economic weakness → reduce FDI and investor confidence → negative impact on investment despite the competitive boost."

Reserve limitations: "Defending a currency peg requires foreign exchange reserves. A small economy may exhaust reserves — as seen in many ERM crises."

Examiner Alerts

Top Errors from Examiner Reports

Confusing managed ER with interest rate policy (P3 Oct 2020): "Major problem — students described interest rate policy as exchange rate policy." These are two distinct mechanisms.

Direction errors on managed ER: "Typical mistake — saying central bank buys lira and this reduces the supply." If the CB buys domestic currency, it increases demand for it (and reduces supply in circulation) → appreciation.

Appreciation vs revaluation: Using these interchangeably. Appreciation = floating/market. Revaluation = fixed/government. The mechanism is different.

No Marshall-Lerner on depreciation answers: Level 1–2 answer says "depreciation makes exports cheaper." Level 3+ requires the full ML condition with formula and J-curve.

Spending too long on 5-mark questions: "Candidates wrote far too much for 5- and 8-mark questions, running out of time at the end." Full marks in a fraction of the space.

Worked Example: Depreciation Essay Chain

01Level 4 Analysis — Depreciation

Context: Sterling depreciates from £1 = $1.30 to £1 = $1.10.

Level 1 (1–3 marks): "Depreciation makes exports cheaper." ✗ No chain.

Level 3 (7–10 marks): "Sterling depreciates → UK export prices fall in foreign currency → quantity of exports rises → import prices rise in domestic currency → quantity of imports falls → IF |PEDx| + |PEDm| > 1 (Marshall-Lerner met) → CA improves in long run. Short run: J-curve effect as contracts are fixed → CA worsens initially."

Level 4 (11–14 marks): As L3 + micro effects: "Imported raw materials cost more → higher production costs for firms → SRAS shifts left → cost-push inflation. FDI increases as UK assets become cheaper for foreign investors. However, if the depreciation signals economic weakness, it may reduce investor confidence and deter FDI."

Practice Question

Question (5 marks — Paper 3 style):

Explain how the Turkish central bank intervenes in the currency market to prevent excessive depreciation of the Turkish lira.

1

The Turkish central bank operates a managed exchange rate system where it intervenes directly in the forex market.

2

To prevent depreciation, the central bank uses its foreign exchange reserves to buy Turkish lira on the forex market.

3

This increases demand for the lira → the demand curve for lira shifts right.

4

Simultaneously, this reduces the supply of lira in circulation (as lira is absorbed by the central bank).

5

The combined effect raises the price of lira → the exchange rate appreciates (or stops depreciating). However, this depletes foreign reserves, which is unsustainable long-term.

Practice Question

Question (25 marks — Paper 2):

"Evaluate the likely economic effects of a significant depreciation of the exchange rate on the UK economy."

(This appeared in October 2020 Paper 2 — a real past paper question.)

Plan:

Intro: Define depreciation (fall in value under floating system). Thesis: effects are ambiguous — depends on Marshall-Lerner, time period, and structure of the economy.

KAA1:

Current account effect — full depreciation chain. Export prices fall in $ → volume ↑. Import prices rise in £ → volume ↓. If ML met → CA improves. Include forex diagram showing £ supply shift.

KAA2:

Inflationary impact — import prices rise → oil, food, raw materials dearer → SRAS shifts left → cost-push inflation → real incomes fall. Apply: UK imports ~30% of food → significant pass-through.

Eval 1:

J-curve: "In the short run (6–18 months), the CA worsens before improving because contracts are fixed and demand is inelastic. The time period of analysis is therefore critical." Draw J-curve.

Eval 2:

Non-price factors: "UK competitiveness in services (finance, education) depends on quality, not price. Depreciation does not address structural weaknesses in manufacturing."

Concl:

"On balance, a significant depreciation will likely boost the CA in the long run if ML is met, but the inflationary cost reduces real living standards, particularly for import-dependent consumers. The net effect depends on the openness of the economy and the elasticity of trade flows."

Summary

Key Concepts

ConceptKey Point

Balance of PaymentsCurrent + Capital + Financial = 0. UK runs persistent CA deficit.

Exchange Rate SystemsFloating (market), Fixed (government), Managed (hybrid)

Managed ER ≠ Interest RatesDirect: buy/sell currency. Indirect: interest rates → hot money

Marshall-Lerner|PEDx| + |PEDm| > 1 → depreciation improves CA

J-CurveShort run: CA worsens (fixed contracts). Long run: CA improves

CompetitivenessPrice (ULC, ER) + Non-price (quality, innovation, branding)

Must-Know Diagrams

✓ Forex market (S£ / D£) with shift

✓ J-curve (CA balance vs time)

✓ AD/AS showing depreciation effects

Must-Know Definitions

✓ Appreciation vs depreciation vs revaluation vs devaluation

✓ Marshall-Lerner (+ formula)

✓ J-curve effect

✓ Current account components

Exam Tip

This topic is extremely high-frequency — it appeared in P2 Oct 2020 (depreciation essay), P3 Oct 2020 (Turkey managed ER), P2 Nov 2021 (persistent CA deficit), and P2 2024 (policies to reduce CA deficit). Expect it every series.