Balance of payments

• Explain, using an exchange rate diagram, how the current account and the financial account are each related to the exchange rate.
• Discuss the implications of a persistent current account deficit and of a persistent current account surplus.
• Evaluate expenditure-switching, expenditure-reducing and supply-side policies as ways of correcting a persistent current account deficit.
• Explain the Marshall–Lerner condition and, using a diagram, the J-curve effect.

Balance of payments transactions are also foreign exchange transactions. Every credit item requires non-residents to buy the country's currency, so credits create demand for the currency. Every debit item requires residents to sell the currency to obtain foreign currency, so debits create supply of it. The exchange rate of a floating currency is set by this demand and supply, which is why each account is linked to it.

From the current account to the exchange rate. A current account deficit means that residents are supplying more of their currency, to pay for imports, income and transfers abroad, than non-residents are demanding to pay for exports. Taken on its own this is an excess supply of the currency, which pushes its price down: a depreciation. A current account surplus is an excess demand for the currency from current transactions, which pushes its price up: an appreciation.

From the exchange rate back to the current account. A depreciation makes exports cheaper for foreign buyers and imports dearer for residents. Over time export volumes rise and import volumes fall, so the deficit narrows, provided that demand for exports and imports is price elastic enough (the Marshall–Lerner condition, explained in a later section). An appreciation works in the opposite direction on a surplus. Under a floating exchange rate there is therefore, in principle, an automatic tendency for current account imbalances to correct themselves.

• The tendency is weak when the financial account pulls the other way. The currency's value depends on all demand and supply, and financial flows are often far larger than trade flows.
• It is slow, because the volumes of exports and imports respond to a price change only after a delay (the J-curve).
• It is absent under a fixed exchange rate, where the central bank holds the rate and the adjustment cannot come through the price of the currency.

From the financial account to the exchange rate. Inflows on the financial account, such as foreign direct investment, purchases of shares and bonds and deposits in the country's banks, require non-residents to buy the currency. They raise demand for it and cause an appreciation. Outflows require residents to sell the currency, raise its supply and cause a depreciation. Financial flows respond to interest rates that are higher than in other countries, to the profits expected from investment, and to confidence in the economy and its government. A loss of confidence can produce a sudden, large outflow, known as capital flight, and a sharp depreciation.

From the exchange rate to the financial account. Investors care about the value of their assets in their own currency. If a currency is expected to depreciate, foreign investors expect to lose when they convert their money back, so inflows fall and outflows rise, which brings about the depreciation that was expected. Once a currency has fallen, domestic assets are cheaper for foreign buyers, which can attract direct investment.

The two links interact. A country can run a current account deficit for many years without a depreciation if financial inflows are strong, because the inflows supply the demand for the currency that trade does not. The strong currency keeps exports dear and imports cheap, which in turn keeps the current account in deficit. The position holds for as long as the inflows continue. If they stop, the excess supply of the currency from the current account is no longer offset and the currency falls quickly.

Under a fixed exchange rate the gap between current transactions and private financial flows is met by the central bank. With a current account deficit that private inflows do not cover, it must sell reserve assets to buy its own currency, or the government must borrow officially. Reserves are limited, so a deficit that persists puts the fixed rate itself in doubt.

A current account deficit that lasts for one or two years is easily financed. A persistent deficit has to be financed year after year by a surplus on the financial account, which means selling more assets to non-residents or borrowing more from them every year. Each implication below follows either from the pressure the deficit puts on the currency or from the way it is financed.

• Exchange rates. The deficit is a continuing excess supply of the currency from current transactions, so under a floating rate there is continuing downward pressure and the currency tends to depreciate. A depreciation raises the price of imports, which adds to inflation (imported inflation) and lowers real incomes. If holders of the currency lose confidence the fall can become rapid. Under a fixed rate the central bank must keep buying its own currency, so reserves drain and pressure builds for a devaluation.
• Interest rates. To attract the financial inflows that finance the deficit, or to stop the currency falling, the central bank may have to keep interest rates higher than the domestic economy needs. Lenders also ask for a higher return as the country's foreign debt grows, because the risk of not being repaid is higher. Dearer borrowing reduces investment and consumption, and so slows growth.
• Foreign ownership of domestic assets. A deficit financed by selling assets (firms, property, shares, government bonds) raises the share of the country's assets owned by non-residents. The profits, dividends and interest on those assets then flow abroad every year as debits under income, which worsens later current accounts. There may also be concern about foreign control of important industries.
• Debt. A deficit financed by borrowing adds to the country's foreign debt each year. Interest payments rise with the debt, so resources that could have paid for health, education or investment go to foreign lenders instead: the debt has an opportunity cost. In the extreme the country borrows merely to pay the interest on earlier loans.
• Credit ratings. A country's credit rating is an agency's assessment of how likely it is to repay its debt. Persistent deficits and rising foreign debt signal a higher risk of non-payment, so the rating may be lowered. Lenders then demand higher interest or refuse to lend. Financing the deficit becomes dearer and harder at the moment the country most needs it, and a sudden stop in lending can turn a deficit into a crisis.
• Demand management. Expansionary fiscal or monetary policy raises incomes, and part of every rise in income is spent on imports, so it widens the deficit. A government with a persistent deficit is therefore less free to use expansionary policy against unemployment. To reduce imports, or to reassure lenders, it may have to do the opposite and use contractionary policy even when the economy is weak. The external deficit constrains domestic policy.
• Economic growth. A current account deficit dominated by trade means that net exports are negative, so aggregate demand, output and employment are lower than they would be with balanced trade. Later, interest payments on the debt and the policies needed to correct the deficit hold growth back further. The opposite case is a deficit that reflects imports of capital goods and strong investment: it raises productive capacity and future export earnings, and so supports long-run growth.

The effects fall differently on different groups and at different times. In the short run a deficit allows households, firms and the government together to consume and invest more than the country produces, which raises current living standards. The costs come later and fall on different people: households pay more for imports if the currency falls, firms and home buyers pay higher interest rates, taxpayers service the foreign debt, and workers lose jobs if the deficit is eventually corrected by cutting demand. Exporters and firms that compete with imports are the one group that gains from the depreciation.

The United States is the contrast. Its current account deficit was 3.6% of GDP in 2025 and 4.0% in 2024, and its net international investment position, which is the value of foreign assets owned by its residents minus the value of its assets owned by non-residents, was −US$27.54 trillion at the end of 2025, compared with −US$26.54 trillion a year earlier. Its net liabilities to the rest of the world are large and growing, as the theory predicts, yet there has been no financing crisis, because foreign residents are willing to keep buying its assets. The two cases together show that the implications of a deficit turn on who is willing to finance it and on what terms.

A government that wants to reduce a persistent current account deficit has to raise export revenue, reduce spending on imports, or both. The methods fall into three groups: expenditure-switching policies, expenditure-reducing policies and supply-side policies.

Expenditure-switching policies aim to switch spending, by residents and by foreigners, away from goods produced abroad and towards goods produced at home, without reducing total spending. There are two kinds. The first works through the exchange rate: a devaluation of a fixed currency, or measures that bring about a depreciation of a floating one, such as lower interest rates or sales of the currency by the central bank. The lower exchange rate makes exports cheaper abroad and imports dearer at home, so foreigners buy more of the country's exports and residents replace imports with domestic goods. The second kind is trade protection: a tariff or a quota raises the price or limits the quantity of imports, and a subsidy lowers the price of domestic goods that compete with imports or are exported, so spending again moves towards domestic producers.

Expenditure-reducing policies aim to reduce total spending in the economy, so that spending on imports falls with it. The tools are contractionary fiscal policy (higher taxes or lower government spending) and contractionary monetary policy (higher interest rates). Either reduces aggregate demand, so real output and incomes fall. Households and firms spend part of any change in income on imports, a share called the marginal propensity to import, so when incomes fall, import spending falls: the larger the marginal propensity to import, the larger the fall. There is a second, slower effect: lower demand reduces inflation, so over time the country's goods become more price competitive against foreign goods.

Supply-side policies aim to make domestic producers more competitive, so that exports rise and imports are replaced without any cut in demand. Interventionist policies include spending on education and training, infrastructure, and research and development. Market-based policies include measures that increase competition and make labour markets more flexible. Higher productivity lowers the cost of producing each unit, and better quality and design make demand for the country's goods stronger at any price. Export revenue rises and domestic goods win back sales from imports.

A depreciation or devaluation has two effects on the current account, and they work against each other. The price effect is immediate: every unit of imports now costs more in domestic currency, which worsens the balance. The volume effect takes time: because exports are cheaper abroad and imports dearer at home, the quantity of exports rises and the quantity of imports falls, which improves the balance. Whether the balance improves overall depends on how strongly quantities respond to the change in prices, which is what price elasticity of demand measures.

The Marshall–Lerner condition states the requirement: a depreciation or devaluation improves the current account balance only if the price elasticity of demand for exports plus the price elasticity of demand for imports is greater than one (taking both as positive numbers). If the sum is less than one the balance worsens, and if it is exactly one the balance is unchanged.

The reasoning can be followed in domestic currency, assuming that exporters keep their prices unchanged in their own currency and that trade starts roughly in balance. After a 10% depreciation exports are 10% cheaper for foreign buyers, so the quantity sold rises by the export elasticity × 10%; the domestic-currency price is unchanged, so export revenue rises by the same percentage. Imports cost 10% more in domestic currency and the quantity bought falls by the import elasticity × 10%, so spending on imports changes by about (1 − import elasticity) × 10%. The balance improves if export revenue rises by more than import spending, which is the case when the two elasticities add up to more than one.

The J-curve describes what is usually observed after a depreciation: the current account gets worse before it gets better. The explanation is that the elasticities are different in the short run and the long run. In the short run demand for exports and imports is price inelastic. Trade contracts fix quantities and prices months ahead; firms and consumers take time to notice the new prices, to find other suppliers and to change their habits; exporters need time to raise output. Quantities hardly change, the two elasticities add up to less than one, and the Marshall–Lerner condition is not satisfied. Meanwhile each unit of imports already costs more, so the deficit grows.

In the longer run buyers respond. Residents switch from dearer imports to domestic goods, foreign buyers place larger orders for the cheaper exports, and exporters expand capacity. Demand is more price elastic, the two elasticities add up to more than one, and the condition is satisfied. Export revenue rises faster than import spending and the balance improves, passing its starting level and ending above it.

The J-curve is therefore not a second condition alongside the Marshall–Lerner condition. The condition is about elasticities; the J-curve is the path the current account follows over time because the condition fails in the short run and holds in the long run.

• Spare capacity. Exporters can sell more only if they can produce more. In an economy at full employment the extra foreign demand raises prices instead of output, and the gain in competitiveness is lost.
• No offsetting inflation. Dearer imports raise the cost of living and the cost of imported inputs. If workers win higher wages in response, firms' costs and prices rise and cancel the advantage the depreciation gave.
• No response from trading partners. If other countries devalue as well, or impose trade barriers, relative prices return to where they started.
• A low import content of exports. Where exports are assembled from imported components, a depreciation raises their cost almost as much as it lowers their price abroad.

A policy to correct a deficit is effective if it reduces the deficit, does so within a useful time, lasts, and does not cost more in terms of the other macroeconomic objectives than the deficit itself was costing. No method meets all four tests, and each works well only in particular circumstances.

Three judgements follow. First, the policy has to match the cause: excess demand calls for expenditure reducing, an overvalued currency for expenditure switching, and weak competitiveness for supply-side policies. A policy aimed at the wrong cause either fails or corrects the deficit at an unnecessary cost. Second, the methods work over different periods. Expenditure reducing acts within months, a depreciation within one to a few years, and supply-side policies over many years, so governments usually combine them: restraint of demand to release resources, a lower exchange rate to switch spending, and supply-side reform to make the improvement last. Third, a deficit that is small, financed by stable inflows and paying for investment may not need correcting at all, and the cost of correcting it would then exceed the benefit.

The costs fall on different groups. A depreciation helps exporters and their workers and hurts households, which pay more for imported food, fuel and consumer goods. Expenditure reducing hurts workers who lose their jobs and people who depend on government spending. Protection helps the protected industry at the expense of consumers and of firms that use its products. Supply-side spending is paid for by taxpayers now for a benefit that arrives later.

A persistent current account surplus means that a country earns more from the rest of the world than it spends there, year after year. The matching deficit on its financial account means that it acquires foreign assets each year: it lends to, and invests in, other countries. Its surplus is also, necessarily, other countries' deficit.

• Domestic consumption and investment. A surplus means that the country produces more than it spends at home: part of its output is consumed or invested by foreigners. Households are consuming less than the country's income would allow, so current living standards are below what they could be. The country's saving is larger than its domestic investment, and the difference is invested abroad. Domestic investment may therefore be lower than it would otherwise be, although the foreign assets acquired pay income in later years.
• Exchange rates. The surplus is a continuing excess demand for the currency from current transactions, so under a floating rate the currency tends to appreciate. The appreciation makes exports dearer and imports cheaper and so tends to reduce the surplus. If the central bank prevents the appreciation by selling its own currency and buying foreign currency, its reserve assets grow and the currency stays below the value the market would set.
• Inflation. Two forces work in opposite directions. Positive net exports add to aggregate demand, which causes demand-pull inflation if the economy is near full employment, and a central bank that sells its own currency to hold the exchange rate down increases the money supply. Against this, an appreciation lowers the price of imports and so reduces inflation. Inflation is more likely to rise when the economy has little spare capacity and the currency is held down, and more likely to fall when the currency is allowed to rise.
• Employment. Export industries employ many workers, so a surplus is usually associated with low unemployment. The risk is dependence on foreign demand: a recession in the country's export markets, or new trade barriers there, reduces employment at home, and an eventual appreciation threatens jobs in exporting firms.
• Export competitiveness. An appreciation raises the price of the country's exports in foreign markets and erodes the price competitiveness that produced the surplus. Countries with the matching deficits may also accuse the surplus country of unfair practices and respond with protection against its exports.