Balance of payments, exchange rates and international competitiveness

Q: Does a currency depreciation always improve the current account?

No. The Marshall-Lerner condition must hold: the sum of and must be greater than 1. Even if it holds, the J-curve effect means the current account worsens in the short run before improving, as contracts take time to renegotiate.

Edexcel International A-Level Economics· 4.3.3· 25 min read

1. 1. Full Balance of Payments Structure and Imbalances★★☆☆☆⏱ 6 min

The balance of payments (BoP) is a record of all financial transactions between a country and the rest of the world over a given period, usually one year. It is split into two core accounts: the current account, and the capital and financial account, which must always sum to zero (with a small statistical discrepancy for data errors).

📘 Definition

Capital and Financial Account

The part of the BoP that records transactions in assets and liabilities, including foreign direct investment (FDI), portfolio investment, central bank foreign currency reserves, and capital transfers like debt forgiveness.

Example:

A Chinese firm buying a UK manufacturing plant counts as a credit entry on the UK’s capital and financial account.

Current account imbalances (deficits or surpluses) arise from factors including relative inflation rates, consumer spending on imports, commodity price shifts, and relative competitiveness. Policies to reduce a current account deficit include expenditure switching policies (e.g. tariffs, currency devaluation) and expenditure reducing policies (e.g. higher interest rates, austerity).

📐 Worked Example

Explain how a rise in global oil prices would impact the current account of a net oil importing country like Japan.

1
Step 1: Identify the impact on import values: Japan is a net oil importer, so a rise in global oil prices increases the total value of its oil imports, ceteris paribus.
2
Step 2: Link to current account balance: Higher import values increase the debit entry on the current account’s trade in goods balance.
3
Step 3: Final outcome: Assuming no offsetting rise in export values or other current account inflows, Japan’s current account deficit will widen, or its surplus will shrink.

Exam tip:

For 4 mark explain questions, always include a clear two-stage causal chain, and reference context where provided.

2. 2. Exchange Rate Regimes and Determinants★★★☆☆⏱ 7 min

Exchange rate regimes are classified into three core types: floating, fixed, and managed. Floating exchange rates are determined purely by market supply and demand for the currency, with no central bank intervention. Fixed exchange rates are pegged to another currency or commodity, with the central bank intervening to maintain the pegged value. Managed (or dirty float) regimes combine market forces with occasional central bank intervention to avoid extreme volatility.

📘 Definition

Depreciation vs Devaluation

$e = USD per GBP$ , so a fall in $e$ is a depreciation of GBP

Depreciation is a fall in the value of a currency under a floating regime, driven by market forces. Devaluation is a deliberate downward adjustment of a currency’s value by the central bank under a fixed regime.

Factors influencing floating exchange rates include relative interest rates (higher rates attract hot money, increasing demand for the currency), relative inflation rates (higher inflation makes exports less competitive, reducing demand for the currency), current account performance, speculative expectations, and capital flight. Central bank intervention tools include buying/selling foreign currency reserves, adjusting interest rates, and quantitative easing.

📐 Worked Example

Draw a fully labelled diagram to show the impact of a rise in UK base interest rates on the value of the pound sterling (GBP) against the US dollar (USD).

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Step 1: Axes: Label the y-axis 'Exchange rate (USD per GBP)' and the x-axis 'Quantity of GBP'.
2
Step 2: Initial curves: Draw downward sloping demand for GBP ( $D_{£1}$ ) and upward sloping supply of GBP ( $S_{£1}$ ), mark initial equilibrium $e_{1}$ at their intersection.
3
Step 3: Shift: Higher UK interest rates attract foreign hot money investors seeking higher returns, so demand for GBP increases to $D_{£2}$ .
4
Step 4: Outcome: Mark the new equilibrium $e_{2}$ , which is higher than $e_{1}$ , indicating an appreciation of GBP against USD.

Exam tip:

When drawing exchange rate diagrams, always label both axes clearly with the currency pair, and name the shift factor to secure full 4 marks for diagram questions.

3. 3. Impact of Exchange Rate Shifts: Marshall-Lerner Condition and J-Curve★★★★☆⏱ 7 min

A currency depreciation or devaluation can impact all macroeconomic indicators, including the current account balance, inflation, employment, growth, and FDI flows. The key condition for a depreciation to improve the current account is the Marshall-Lerner condition.

📘 Definition

Marshall-Lerner Condition

A depreciation will improve the current account balance only if the sum of the price elasticity of demand for exports ( $P E D_{x}$ ) and the price elasticity of demand for imports ( $P E D_{m}$ ) is greater than 1.

Example:

If $P E D_{x} = 0.8$ and $P E D_{m} = 0.5$ , the sum is 1.3 > 1, so the Marshall-Lerner condition holds, and the current account will improve in the long run.

Even if the Marshall-Lerner condition holds, the J-curve effect means the current account will worsen in the short run before improving. This is because import and export contracts are fixed in the short run, so the value of imports rises immediately after depreciation, while export volumes take time to rise as foreign buyers adjust to lower export prices.

📐 Worked Example

Examine why a 10% devaluation of the Indian rupee may not improve India’s current account in the first 6 months after the policy is introduced.

1
Step 1: Reference the J-curve effect: In the short run, most import and export contracts are pre-negotiated and fixed in volume terms.
2
Step 2: Short run impact: A devaluation makes imports more expensive in rupee terms, so the total value of imports rises immediately, while export volumes have not yet increased as foreign buyers take time to switch to cheaper Indian exports.
3
Step 3: Outcome: This causes the current account to worsen in the first 6 months, before contract renegotiation leads to higher export volumes and lower import volumes, improving the current account if the Marshall-Lerner condition holds.
4
Step 4: Additional evaluation point: If India’s imports are mostly price inelastic necessities like oil and medicine, the Marshall-Lerner condition may not hold even in the long run, so the current account may never improve.

Exam tip:

For 8 mark examine questions, include 3-4 stages of analysis plus one brief evaluation point (e.g. time lags, elasticity values) to reach the top level.

4. 4. International Competitiveness: Measures and Policies★★★☆☆⏱ 5 min

International competitiveness refers to the ability of a country’s firms to sell goods and services profitably in international markets, while maintaining and raising the real incomes of its population. It is a key driver of current account performance, long run growth, and employment.

📘 Definition

Relative Unit Labour Costs

The most commonly used measure of international competitiveness, calculated as the cost of labour per unit of output in a country, compared to the same measure for its major trade partners. Lower relative unit labour costs indicate higher competitiveness.

Example:

If German unit labour costs rise by 2% while French unit labour costs rise by 5%, Germany’s competitiveness relative to France improves.

Factors influencing international competitiveness include labour productivity, wage growth, exchange rate levels, regulation costs, investment in infrastructure and R&D, and relative inflation rates. Policies to improve competitiveness include supply side policies (e.g. education and training to raise productivity, deregulation to reduce firm costs), tax incentives for R&D, and investment in infrastructure.

📐 Worked Example

Explain how a government policy to increase funding for vocational training would improve a country’s international competitiveness.

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Step 1: Link training to productivity: Higher vocational training funding improves the skills of the labour force, increasing labour productivity (output per worker).
2
Step 2: Link productivity to unit labour costs: Higher productivity reduces unit labour costs, as each worker produces more output for the same wage cost.
3
Step 3: Outcome: Lower unit labour costs reduce the relative price of the country’s exports, making them more competitive in global markets, increasing export demand.

Exam tip:

When evaluating policies to improve competitiveness, always consider time lags (e.g. training policies take 3-5 years to impact productivity) and opportunity cost (funding for training could be used for other public services).

5. Common Pitfalls

Wrong move:

Confusing appreciation/revaluation or depreciation/devaluation

Why:

Appreciation/depreciation apply only to floating (market-driven) regimes, revaluation/devaluation apply only to fixed (policy-driven) regimes. Mixing these up costs knowledge marks.

Correct move:

Always specify the exchange rate regime when describing a currency value change, and use the correct term for that regime.

Wrong move:

Stating that currency depreciation always improves the current account

Why:

This ignores the required Marshall-Lerner condition and J-curve effect evaluation points, leading to lost marks in analysis and extended questions.

Correct move:

Always reference that the current account only improves if $P E D_{x} + P E D_{m} > 1$ , and worsens in the short run due to contract time lags.

Wrong move:

Forgetting the capital and financial account offsets the current account

Why:

A current account deficit is not inherently bad if it is funded by productive FDI inflows, so ignoring the offsetting account limits evaluation depth.

Correct move:

When analysing current account imbalances, reference the offsetting capital and financial account position, and evaluate if the imbalance is sustainable.

Wrong move:

Labeling exchange rate diagram axes incorrectly, e.g. 'price' instead of currency pair

Why:

Unlabelled or incorrectly labeled axes cost up to 2 marks per diagram question.

Correct move:

Always label the y-axis with the exact currency pair (e.g. USD per GBP) and x-axis with quantity of the domestic currency.

Wrong move:

Confusing relative unit labour costs with absolute wage levels

Why:

A country with higher absolute wages may be more competitive if its productivity is much higher, so this error undermines analysis of competitiveness drivers.

Correct move:

Always link wage growth to productivity when discussing competitiveness, not just absolute wage levels.

6. Quick Reference Cheatsheet

Concept	Key Detail	Exam Evaluation Point
BoP Accounts	Current + Capital & Financial = 0	Current account deficit is only unsustainable if funded by short term hot money, not FDI
Exchange Rate Regimes	Floating = market, Fixed = pegged, Managed = mix	Fixed regimes reduce volatility but limit monetary policy autonomy
Marshall-Lerner Condition	$P E D_{x} + P E D_{m} > 1$ for depreciation to improve CA	Most goods are inelastic short run, so ML rarely holds immediately
J-Curve Effect	CA worsens then improves post-depreciation	Time lags last 6-18 months, depending on contract length
International Competitiveness	Key measure: relative unit labour costs	Supply side policies to improve competitiveness have 3-10 year time lags

7. Frequently Asked

What is the difference between currency appreciation and revaluation?

Appreciation is a rise in currency value under a floating regime, driven by market forces. Revaluation is a deliberate upward adjustment of a currency’s value by a central bank under a fixed exchange rate regime.

Does a currency depreciation always improve the current account?

No. The Marshall-Lerner condition must hold: the sum of $P E D_{x}$ and $P E D_{m}$ must be greater than 1. Even if it holds, the J-curve effect means the current account worsens in the short run before improving, as contracts take time to renegotiate.

How is international competitiveness measured?

Key measures include relative unit labour costs (labour cost per unit of output vs trade partners), relative export prices (average export price vs trade partners), and relative labour productivity (output per worker vs trade partners).

Going deeper

official_specEdexcel IAL Economics 2018 SpecificationRefer to section 4.3.3 for full topic guidance
practice_questionsUnit 4 Topic 3 Exam Style QuestionsAligned to 2018 spec mark schemes

What's Next

Now that you have mastered balance of payments, exchange rates, and international competitiveness, you are ready to progress to more advanced Edexcel IAL Economics Unit 4 global economy topics. This sub-topic is frequently combined with globalisation and trade policy for 14 and 20 mark extended evaluation questions, so practice linking exchange rate shifts to trade patterns, growth, and employment outcomes. Prioritize timed practice drawing the J-curve and exchange rate determination diagrams, as these are required for top marks in analysis questions. When structuring extended answers, build clear multi-stage KAA chains, and include balanced evaluation points covering time lags, elasticity values, policy trade-offs, and context-specific 'it depends' factors to reach the top level bands.