# Balance of payments adjustment (HL only)

> IB Economics HL · Unit 4: The Global Economy
> Source: https://www.owlsprep.com/study/ib-economics-hl-u4-balance-of-payments-adjustment/

This sub-topic explores how countries correct balance of payments (BoP) disequilibria, covering exchange rate adjustments, policy approaches, and core theoretical conditions like the Marshall-Lerner condition and J-curve effect, required for IB HL Paper 2 and 3.

**Prerequisites:** [Balance of payments accounts](https://www.owlsprep.com/study/ib-economics-hl-u4-balance-of-payments-accounts/); [Exchange rate determination](https://www.owlsprep.com/study/ib-economics-hl-u4-exchange-rates/); [Price elasticity of demand](https://www.owlsprep.com/study/ib-economics-sl-unit-2-elasticity/)

## Learning objectives

- Explain how exchange rate changes correct balance of payments disequilibria
- State and apply the Marshall-Lerner condition to devaluation outcomes
- Describe and explain the J-curve effect of exchange rate adjustment
- Compare and contrast expenditure-switching and expenditure-reducing policies
- Evaluate the effectiveness of different balance of payments adjustment strategies

## Exchange Rate Adjustment and the Marshall-Lerner Condition

**Balance of Payments Disequilibrium** — A persistent current account deficit (or surplus) that requires policy adjustment to resolve, as it cannot be sustained indefinitely through financial account inflows.

*Example:* Many Eurozone peripheral countries had persistent current account deficits after joining the currency union.

When a country has a persistent current account deficit, a common adjustment is devaluation (for fixed exchange rates) or depreciation (for floating rates), which makes exports cheaper for foreign buyers and imports more expensive for domestic consumers. This should reduce the deficit, but only if a specific condition is met.

**Marshall-Lerner Condition** — Devaluation or depreciation will improve the current account balance if and only if the sum of the price elasticities of demand for exports and imports is greater than 1: $PED_x + PED_m > 1$.

*Notation:* PED_x = PED of exports; PED_m = PED of imports

**Worked example:** A country with a current account deficit devalues its currency. $PED_x = 0.6$, $PED_m = 0.5$. Will devaluation improve the deficit?

1. Step 1: Calculate the sum of the two elasticities:
2. $$0.6 + 0.5 = 1.1$$
3. Step 2: Compare the sum to the Marshall-Lerner threshold of 1: $1.1 > 1$
4. Step 3: Conclusion: The Marshall-Lerner condition is satisfied, so devaluation will improve the current account deficit.

> **exam_tip**
>
> Always include both elasticities in your calculation. Examiners regularly test whether you forget to include either export or import elasticity.

*Calculator:* forbidden

## The J-Curve Effect

Even when the Marshall-Lerner condition holds in the long run, the current account often worsens immediately after devaluation before improving. This time lag is called the J-curve effect.

**J-Curve Effect** — The tendency for a country's current account deficit to initially worsen following devaluation/depreciation, before improving over time into a better balance, creating a J-shaped curve when plotted against time.

The J-curve occurs because trade volumes are sticky in the short run: existing trade contracts are already agreed, so import volumes do not fall immediately. Higher import prices raise the total import bill immediately, worsening the deficit. Over 12-24 months, consumers and firms adjust their behaviour, volumes respond to price changes, and the deficit starts to improve.

**Worked example:** Explain why the J-curve occurs when a country devalues to correct a current account deficit.

1. 1. Immediately after devaluation, import prices rise but existing trade contracts mean import volumes stay the same. Total import spending increases, so the deficit widens.
2. 2. In the short run, demand for exports and imports is inelastic, so the Marshall-Lerner condition is not satisfied yet.
3. 3. Over time, demand becomes more elastic: consumers switch to cheaper domestic goods, foreign demand for exports rises.
4. 4. The Marshall-Lerner condition is now satisfied, export revenues rise faster than import spending, and the deficit improves, eventually moving to a better balance than before devaluation.

> **info**
>
> The J-curve only describes the time path of adjustment, it does not contradict the Marshall-Lerner condition.

*Calculator:* forbidden

## Expenditure-Switching vs Expenditure-Reducing Policies

Governments use two broad categories of policy to correct current account deficits: expenditure-switching and expenditure-reducing policies.

**Comparing methods**

The two policy types have different mechanisms and outcomes:

- **Expenditure-Switching Policies** — Policies that switch spending from imports to domestically produced goods, and foreign spending to domestic exports. Examples: devaluation, import tariffs, quotas.
  - Pros: Avoids the recession caused by contractionary policy, improves export competitiveness long-term.
  - Cons: Can cause imported inflation, may trigger retaliation from trading partners, depends on elasticities to work.

- **Expenditure-Reducing Policies** — Policies that reduce overall aggregate demand in the economy, which reduces spending on all goods including imports. Examples: contractionary fiscal policy (higher taxes, lower spending), contractionary monetary policy (higher interest rates).
  - Pros: Effective for large persistent deficits, also reduces domestic inflation.
  - Cons: Causes higher unemployment and lower economic growth, politically unpopular.

**Worked example:** A country has a 4% current account deficit and 6% inflation. Which policy type is more appropriate for adjustment?

1. Step 1: Identify the dual imbalance: current account deficit plus high domestic inflation.
2. Step 2: Expenditure-reducing policy uses contractionary fiscal/monetary policy, which reduces both aggregate demand (cutting import spending to reduce the deficit) and reduces inflationary pressure.
3. Step 3: Expenditure-switching policy like devaluation would increase imported inflation, worsening the existing inflation problem.
4. Step 4: Conclusion: Expenditure-reducing policy is more appropriate for this economy.

*Calculator:* forbidden

## Long-Run Adjustment Through Supply-Side Policy

For countries in a currency union or with fixed exchange rates that cannot devalue, long-run adjustment of persistent current account deficits relies on supply-side policies to improve export competitiveness. These policies aim to increase productivity, reduce domestic production costs, and make exports more competitive in global markets.

**Check your understanding**

Test your understanding of core concepts

1. If PEDx = 0.8 and PEDm = 0.5, does devaluation improve the current account?

   - No, it worsens the deficit
   - Yes, it improves the deficit
   - No change to the deficit
   - Only improves in the short run

   *Why:* Sum of elasticities = 1.3 > 1, so the Marshall-Lerner condition is satisfied.

2. Which of the following is an expenditure-switching policy?

   - Higher income tax
   - Higher interest rates
   - Import tariff
   - Lower government spending

   *Why:* An import tariff switches domestic spending from imports to domestic goods, so it is expenditure-switching. The other options are all expenditure-reducing.

## Common pitfalls

- **Wrong:** Only using one elasticity (exports or imports) to test the Marshall-Lerner condition
  - Why it fails: Examiners intentionally design questions to catch this common mistake, leading to lost marks for incorrect conclusions
  - Correct: Always add the price elasticity of demand for exports and the price elasticity of demand for imports before comparing the sum to 1
- **Wrong:** Claiming the J-curve effect disproves the Marshall-Lerner condition
  - Why it fails: The J-curve describes short-run vs long-run elasticity differences, not a failure of the condition
  - Correct: Explain that elasticities are low in the short run (condition fails) and rise over time (condition holds), which creates the J-curve shape
- **Wrong:** Confusing expenditure-switching and expenditure-reducing policies
  - Why it fails: Similar names lead to misclassification in exam answers, which is a common marker for weak understanding
  - Correct: Remember: *switching* = switch what you buy (imports vs domestic), *reducing* = reduce how much you buy overall
- **Wrong:** Assuming devaluation always improves the current account deficit
  - Why it fails: Many students only learn the price effect of devaluation, not the quantity effect that depends on elasticities
  - Correct: Always reference the Marshall-Lerner condition when evaluating whether devaluation will improve a deficit

## Cheatsheet

| Concept | Key Rule | Exam Note |
| --- | --- | --- |
| Marshall-Lerner Condition | $PED_x + PED_m > 1$ | Always sum both elasticities |
| J-Curve Effect | Deficit worsens first, improves later | Caused by sticky short-run contracts |
| Expenditure-Switching | Switch spending from imports to domestic | Examples: devaluation, tariffs |
| Expenditure-Reducing | Cut AD to reduce import spending | Examples: contractionary policy |

## What's next

Understanding balance of payments adjustment is critical for analyzing core macroeconomic policy conflicts between internal balance (low unemployment, low inflation) and external balance (a sustainable BoP position). This sub-topic also underpins analysis of fixed vs floating exchange rate systems and the economics of currency unions, where member countries cannot adjust exchange rates to correct persistent BoP imbalances. These concepts are regularly tested in both Paper 2 essay questions and Paper 3 data response questions for IB Economics HL. Building on this knowledge, you will next explore broader topics in global economic integration and policy coordination.

- [Exchange Rate Systems](https://www.owlsprep.com/study/ib-economics-hl-u4-exchange-rate-systems/)
- [Economic Integration](https://www.owlsprep.com/study/ib-economics-hl-u4-economic-integration/)

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