4.6 Balance of payments

What the balance of payments records

A country’s residents are its households, firms and government, together with organisations based in the country. Every time a resident buys from, sells to, lends to, borrows from or gives money to a non-resident, the transaction is recorded in the balance of payments. A British tourist paying for a hotel in Spain, a Japanese car maker building a factory in the UK and a Nepalese worker in Qatar sending money home are all balance of payments transactions, for the countries involved.

The balance of payments measures flows over a period of time, not stocks at a point in time. It records how much a country exported this year, not the total value of everything it has ever exported, and how much foreign investment arrived this year, not the total stock of foreign-owned assets.

Credit items and debit items

Every transaction is entered either as a credit or as a debit. The simplest way to classify it is to follow the money. If the transaction brings money into the country from abroad, it is a credit and has a plus sign. If money leaves the country, it is a debit and has a minus sign.

Exports are credits, because foreigners pay residents for goods and services. Imports are debits, because residents pay foreigners. The same logic applies to income, transfers and investment: money arriving is a credit, money leaving is a debit.

The diagram uses the UK as the example. A German firm buying machinery from a UK manufacturer pays the UK firm, so the export is a credit for the UK. A UK resident buying shares in a US company sends money to the United States, so the purchase is a debit for the UK, even though the resident now owns a foreign asset.

Surpluses and deficits on an account

The balance of payments is divided into three accounts: the current account, the capital account and the financial account. For each account, the balance is the total of its credits minus the total of its debits.

• If credits are greater than debits, the account is in surplus (a positive balance).

• If debits are greater than credits, the account is in deficit (a negative balance).

• If credits equal debits, the account is in balance.

The same idea applies to the parts of each account. A country can have a deficit on its trade in goods and a surplus on its trade in services at the same time, as the UK and the United States both do. What matters for analysis is the size of each balance, usually measured as a percentage of GDP so that countries of different sizes can be compared.

The current account

The current account records the flows that are part of a country’s income and spending in the current period: trade in goods and services, income earned on work and investment, and one-way transfers. It is the account that receives the most attention, because it shows whether a country earns more from the rest of the world than it spends there.

Balance of trade in goods

Goods are physical products: oil, cars, smartphones, wheat, clothing. The balance of trade in goods compares the revenue from exports of goods with the spending on imports of goods. It is sometimes called the visible trade balance, because goods can be seen and counted as they cross the border.

For most countries this is the largest item in the current account. The United States, the UK and India have large deficits on trade in goods; Germany, China and oil exporters such as Saudi Arabia and Norway usually have large surpluses.

Balance of trade in services

Services are intangible: tourism, transport and shipping, banking, insurance, education, consulting, software and the use of intellectual property. The balance of trade in services compares exports of services with imports of services. It is sometimes called the invisible trade balance.

Classifying services follows the same rule as goods. When a Chinese student pays fees to a university in Australia, Australia exports an education service, even though the student travels to Australia to receive it. When an Indian software firm writes code for a client in Germany, India exports a service. India’s exports of services reached about US$412 billion in 2025, almost half of which were computer and information services.

Sources: World Bank, World Development Indicators, BX.GSR.NFSV.CD and BX.GSR.CCIS.CD (2026).

Income (primary income)

Residents also earn income from abroad by working there for short periods or by owning foreign assets. The income item records wages paid to workers across borders and investment income: interest on loans and bonds, profits of foreign subsidiaries and dividends on shares. In official statistics it is called primary income.

Income flows depend on what each country owns abroad. When a US company owns a factory in Mexico, the profits it sends back to the United States are an income credit for the US and an income debit for Mexico. Countries that have received large amounts of foreign investment over many years, such as many economically less developed countries, often have a deficit on the income account because profits and interest flow out to foreign owners.

Current transfers (secondary income)

Current transfers are one-way payments: money is given and nothing is received in return. In official statistics they are called secondary income. The largest are workers’ remittances, foreign aid for consumption (for example food aid or budget support), payments to and from international organisations, and pensions paid to people living abroad.

For some economies, transfers are very large. Personal remittances received in Nepal were equal to about 26% of GDP in 2023 and 2024, and about 32% in 2025. Without them, Nepal’s large deficit on trade in goods would leave a much larger current account deficit.

Sources: World Bank, World Development Indicators, BX.TRF.PWKR.DT.GD.ZS (2026).

The current account balance

The current account balance adds the four balances together. In symbols:

When the total is negative, the country has a current account deficit: it is spending more abroad, on imports, income payments and transfers, than it earns from abroad. When the total is positive, it has a current account surplus.

A current account deficit means that the country is using more goods and services than it produces, and paying for the difference by borrowing from abroad or selling assets to foreigners. A surplus means the reverse: the country produces more than it uses and lends the difference abroad, or buys foreign assets with it.

The trade balance in goods and services, exports minus imports, is the same quantity as net exports (X − M) in aggregate demand. A larger trade deficit therefore reduces aggregate demand, and a larger trade surplus adds to it. The income and transfer items are not part of aggregate demand, which is why the trade balance and the current account balance can move differently.

A current account calculation adds up the credits and debits item by item. The data for Country A are hypothetical, in US$ billion, for one year.

The capital account

The capital account is usually the smallest of the three accounts. It records two kinds of transaction, neither of which is part of current income or of normal investment flows.

• Capital transfers: one-way transfers of ownership of capital or of money for investment. The main examples are debt forgiveness (when a creditor government cancels a loan, the debtor country records a capital transfer received), grants for capital projects such as a donor paying for a bridge or a hospital, and the assets that migrants bring with them when they move country.

• Transactions in non-produced, non-financial assets: buying and selling assets that were not produced and are not financial. Examples are land bought by a foreign government for an embassy, rights to natural resources, and marketing assets such as brand names, trademarks and licences.

For most countries, the capital account balance is close to zero. It matters mainly for low-income countries that receive large debt relief or capital grants: when official creditors cancel debt, the amount appears as a large capital account credit for the debtor country in that year.

The financial account

The financial account records flows of investment and lending between countries: purchases and sales of financial assets such as shares, bonds and bank deposits, and investment in real assets such as factories. It shows how a country finances a current account deficit, or what it does with a current account surplus.

The rule of following the money still applies. When foreigners invest in the country, money flows in and the entry is a credit (+). When residents invest abroad, money flows out and the entry is a debit (−). A financial account surplus means that more investment and lending has come into the country than has gone out of it, so that, on balance, the country has borrowed from abroad or sold assets to foreigners.

Foreign direct investment

Foreign direct investment (FDI) is long-term investment by a firm in another country in which the investor gains a lasting interest and a significant degree of control, normally an ownership share of at least 10%. Building a new factory abroad, buying a foreign company or setting up a foreign subsidiary are all FDI.

A Japanese car maker building a plant in the UK is an FDI credit for the UK. A UK supermarket chain buying a retail chain in Poland is an FDI debit for the UK. FDI is usually stable: factories cannot be moved out of a country quickly, so FDI inflows are less likely than other flows to reverse suddenly.

Portfolio investment

Portfolio investment is the purchase of financial assets, mainly shares and bonds, without gaining control of the firm or government that issues them. A US investment fund buying shares in an Indian company, or a German pension fund buying UK government bonds, is portfolio investment.

Portfolio flows can move very quickly. Investors can sell shares or bonds in seconds and move the money elsewhere, so portfolio inflows can reverse when interest rates abroad rise or confidence falls. Short-term flows that move between countries in search of the highest return or in response to expected exchange rate changes are called hot money.

Reserve assets

A country’s central bank holds stocks of foreign currencies (mostly US dollars, euros and yen), gold and other foreign assets. These reserve assets can be used to pay for imports and foreign debt in an emergency, and to intervene in the foreign exchange market to influence the exchange rate.

Changes in reserves are recorded in the financial account with a sign that often confuses students. When the central bank adds to its reserves, it buys foreign assets, so money flows out of the country: the entry is a debit (−). When the central bank uses reserves, it sells foreign assets and brings money back into the country: the entry is a credit (+). A country running down its reserves to pay for a current account deficit therefore shows a positive reserve assets entry.

Official borrowing and other investment

Official borrowing is borrowing by the government or the central bank from foreign governments and international institutions, for example a loan from the International Monetary Fund (IMF) to a country in a balance of payments crisis. Like other borrowing from abroad, it is a credit, because money flows into the country. Repaying it is a debit.

Official statistics also include a large item called other investment, which covers bank loans and deposits between countries and trade credit between firms. When a UK bank lends to a firm in South Africa, the loan is an outflow for the UK; when a foreign bank deposits money in a London bank, it is an inflow.

Sovereign wealth funds

Some governments that earn large surpluses from exports of oil and other commodities invest them abroad through a sovereign wealth fund. The purchases of foreign shares, bonds and property are financial account debits, because money flows out of the country.

Norway’s Government Pension Fund Global, built from the country’s oil and gas revenue, was worth about 21,300 billion kroner at the end of 2025. It invests only in international financial markets, so the oil revenue does not add directly to spending in the Norwegian economy. Norway’s current account surplus reached about 28% of GDP in 2022, when gas prices were very high, and the fund’s foreign purchases are the matching financial account outflow.

Sources: Wikipedia, “Government Pension Fund of Norway”, citing Norges Bank Investment Management (accessed 2026); IMF, World Economic Outlook database (October 2026).

Why the balance of payments always balances

However large a country’s current account deficit is, its balance of payments as a whole always sums to zero. This follows from how transactions are recorded: every international transaction has two sides, and both are recorded.

Suppose a UK firm imports US$10 million of machinery from the United States. The import is a current account debit of US$10 million. The UK firm must also pay for it. If it pays from a UK bank’s dollar deposits, the UK’s holdings of foreign assets fall by US$10 million, which is a financial account credit. If instead the US supplier accepts payment in pounds and keeps them in a London bank account, a US resident has acquired a UK asset, which is also a financial account credit. Either way, the debit on the current account is matched by an equal credit in the financial account.

The same logic holds for every transaction. A country can only buy more from the rest of the world than it sells if it pays for the difference, and it can only pay by borrowing from foreigners, selling assets to them or running down its reserves. All three are credits in the financial account.

What the identity shows

The identity links the accounts directly. If the capital account balance is close to zero, a current account deficit must be matched by a financial account surplus of the same size. A country with a current account deficit is, in effect, a net borrower from the rest of the world, or a net seller of its assets to foreigners. A country with a current account surplus is a net lender, or a net buyer of foreign assets.

Over time, these flows build up into stocks. A country that runs current account deficits for many years accumulates foreign liabilities: foreigners own more and more of its firms, bonds and property. The difference between the foreign assets a country’s residents own and the domestic assets that foreigners own is its net international investment position.

Net errors and omissions

In practice, the recorded accounts never sum exactly to zero. Statistical agencies collect data from customs records, surveys of firms, banks and tourism, and many transactions are missed, recorded late or valued differently by each side. Smuggling, unrecorded cash flows and errors in estimates all play a part.

Net errors and omissions is calculated as whatever figure makes the total exactly zero. It is often large: for the United States in the second quarter of 2026 it was about −US$125 billion, half the size of the current account deficit.

Sources: US Bureau of Economic Analysis, “U.S. International Transactions, 2nd Quarter 2026: Historical Comparisons” (24 September 2026). The BEA publishes the financial account as net borrowing of −369.7; its sign is reversed here so that a net inflow is a credit (+).

The US data show every part of the identity at work. The large deficit on trade in goods is partly offset by a surplus on services, but the current account is still US$246 billion in deficit in a single quarter, about 3.0% of US GDP. The United States paid for it with a net inflow of US$370 billion of foreign investment and lending into US assets, and the statistical discrepancy accounts for the rest.

The current account and the exchange rate (HL only)

Every credit in the current account creates demand for the domestic currency, and every debit creates a supply of it. When a US firm buys UK machinery, it must pay in pounds, so it buys pounds with dollars on the foreign exchange market. When a UK household buys a US holiday, it sells pounds to buy dollars. In a floating exchange rate system, the current account is therefore one of the main forces behind the demand for and supply of a currency.

A current account deficit puts downward pressure on the currency

Consider an economy whose only international transactions are on the current account. The demand for pounds then comes from the credits (exports, income and transfers received) and the supply of pounds from the debits (imports, income and transfers paid). At the exchange rate where the two are equal, the current account balances.

In the diagram, the exchange rate e₁ is above the rate e* at which current account flows balance. At e₁, UK residents supply Qm pounds to pay for imports, while foreigners demand only Qx pounds for UK exports. The horizontal gap Qm − Qx is the current account deficit, measured in pounds. Because more pounds are being sold than bought, the pound depreciates towards e*.

The depreciation itself starts to correct the deficit. A cheaper pound makes UK exports cheaper for foreign buyers and imports dearer for UK buyers, so export volumes rise and import volumes fall. In this simple model a floating exchange rate is self-correcting: a current account deficit causes a depreciation, and the depreciation reduces the deficit. Whether the deficit actually shrinks depends on the price elasticities of demand for exports and imports, which is the subject of the Marshall–Lerner condition.

The reverse also holds. A current account surplus means that more of the currency is demanded than supplied at the current rate, so the currency tends to appreciate. The appreciation makes exports dearer and imports cheaper, which tends to reduce the surplus.

The exchange rate as a cause of current account changes

The link runs in both directions. A change in the exchange rate for any other reason, such as a rise in interest rates or speculation, changes the relative prices of exports and imports and so moves the current account. A currency that appreciates because of capital inflows makes exports less competitive and imports cheaper, which tends to widen a current account deficit. A currency that depreciates after a loss of confidence tends, after a time lag, to narrow it.

In a fixed exchange rate system, the self-correcting mechanism is blocked. A country with a current account deficit and a fixed rate faces excess supply of its currency at the fixed rate, and the central bank must buy its own currency with reserve assets to hold the rate. The deficit then appears as a fall in reserves (a positive reserve assets entry in the financial account) instead of as a depreciation. This can continue only as long as the reserves last.

The financial account and the exchange rate (HL only)

Financial account flows are now far larger than trade flows on the foreign exchange market. When foreign firms build factories in a country, when foreign investors buy its shares and bonds, or when foreign banks lend to it, they must first buy its currency. Financial account inflows therefore increase the demand for the currency, and outflows (residents investing abroad) increase its supply.

• Higher interest rates attract portfolio inflows and hot money, which increase demand for the currency and cause it to appreciate.

• Strong growth prospects or a good investment climate attract foreign direct investment, with the same effect.

• A loss of confidence, a cut in the country’s credit rating or higher interest rates abroad cause investors to sell their assets and move the money out, increasing the supply of the currency and causing it to depreciate.

• Central bank intervention is also a financial account flow: buying the domestic currency with reserves raises demand for it; selling it to add to reserves raises supply.

How financial inflows finance a current account deficit

The two accounts meet in the foreign exchange market. A country with a current account deficit supplies more of its currency for imports than foreigners demand for its exports. If foreign investors want to buy its assets, their demand for the currency fills the gap, and the exchange rate need not fall.

In the left-hand panel, D£₁ shows the demand for pounds from current account credits alone. At e₁, it falls short of the supply of pounds by the current account deficit. Financial inflows add to demand, shifting it to D£₂, which meets the supply curve at e₁. The financial account surplus is exactly the size of the current account deficit, which is the balance of payments identity seen in the currency market.

The right-hand panel shows the risk. If foreign investors stop buying the country’s assets, for example because its debt looks less safe or because interest rates rise elsewhere, demand for the currency falls back to D£₁ and the currency depreciates sharply to e₂. A country that relies on short-term portfolio inflows and hot money to finance a large deficit is exposed to this kind of sudden stop. FDI is less likely to leave quickly.

Strong inflows can widen the current account deficit

Financial inflows can also cause current account deficits. When large inflows make the currency appreciate, exports become less competitive and imports cheaper, so the current account worsens. The United States is the largest example. Foreign governments, central banks and investors want to hold US dollar assets, especially US government bonds, because they are safe and easy to sell. This demand keeps the dollar stronger than it would otherwise be and makes it easy for the United States to finance a current account deficit year after year: in the second quarter of 2026 alone, net financial inflows into the United States were about US$370 billion.

Sources: US Bureau of Economic Analysis (24 September 2026).

Persistent current account deficits (HL only)

A current account deficit in one year is not necessarily a problem. A country may import a large amount of machinery that will raise its exports later, or a temporary fall in an export price may push the account into deficit for a year or two. The concern is a deficit that is large and persistent, lasting for many years, because each year’s deficit must be financed by borrowing from abroad or selling assets to foreigners.

The chart shows two countries with persistent deficits and two with persistent surpluses. The UK’s deficit reached about 5% of GDP in 2016 and the US deficit about 4% of GDP in 2024. Germany’s surplus was above 6% of GDP in every year from 2011 to 2021, while China’s fell from 9% of GDP in 2008 to almost zero in 2018 and then rose again.

Why persistent deficits arise

• Low competitiveness: high costs, low productivity growth or poor product quality reduce exports and raise imports. A low level of international competitiveness is a supply-side cause.

• An overvalued currency: a fixed or managed exchange rate held above its market level makes exports dear and imports cheap.

• Fast growth of domestic demand: when incomes rise quickly, spending on imports rises with them, while exports depend on growth abroad.

• Low national saving relative to investment: if households and the government together save less than the country invests, the gap must be filled with saving from abroad, which is a current account deficit.

• Dependence on imported essentials: an economy that imports most of its fuel, food or medicines faces a larger import bill whenever their world prices rise.

Implications of a persistent current account deficit

The effects of a persistent deficit are interlinked: the need for financial inflows connects the deficit to the exchange rate, interest rates, debt and the scope for other policies.

Exchange rates

A persistent deficit means that the country continuously supplies more of its currency for imports than is demanded for its exports. Unless financial inflows fill the gap, the currency tends to depreciate. A depreciation raises the price of imported goods and inputs, which can cause cost-push inflation and lowers the purchasing power of households. With a fixed or managed rate, the central bank must run down reserves to hold the rate, which cannot continue for ever.

Interest rates

To attract the financial inflows that finance the deficit, and to stop the currency from depreciating too fast, the central bank may have to keep interest rates higher than it otherwise would. Higher interest rates make borrowing more expensive for firms and households, which reduces consumption and investment and can slow growth.

Foreign ownership of domestic assets

A deficit financed by FDI and by sales of shares and property means that more and more of the country’s firms, land and buildings pass into foreign ownership. Foreign ownership can bring capital, technology and jobs, but the profits on the assets then flow abroad as income debits, which adds to future current account deficits. Some governments also worry about foreign control of strategic industries such as energy, ports and telecommunications.

Debt

A deficit financed by borrowing increases the country’s foreign debt. The interest on that debt is paid abroad, which again worsens the income balance in later years. If the debt is in a foreign currency, such as US dollars, a depreciation of the domestic currency increases the burden of repaying it, because more domestic currency is needed to buy each dollar. This is one of the main dangers for economically less developed countries, which often cannot borrow abroad in their own currency.

Credit ratings

Credit rating agencies judge how likely a government is to repay its debt. Persistent deficits, rising foreign debt and falling reserves can lead to a downgrade. A lower rating raises the interest rate the country must pay on new borrowing, and it can make some investors unwilling to lend at all, which makes the deficit harder to finance and can turn a slow problem into a crisis.

Demand management

A persistent deficit limits the choice of macroeconomic policy. A government that wants to reduce unemployment with expansionary fiscal or monetary policy knows that higher incomes will raise spending on imports and widen the deficit, and that lower interest rates may cause the currency to fall and inflows to leave. The need to keep foreign lenders confident may force contractionary policy at a time when the domestic economy needs the opposite.

Economic growth

The effect on economic growth depends on what the deficit pays for. If the country is importing capital goods and receiving FDI that raises productive capacity, the deficit can support faster long-run growth and the debts can be repaid from higher future output. If it is paying for consumption, and if the policies needed to finance it (high interest rates, then a forced contraction) slow the economy, a persistent deficit lowers growth. The trade deficit also reduces aggregate demand through lower net exports.

How serious is a persistent deficit?

Whether a persistent deficit is a problem depends on several factors, and a strong evaluation weighs them for the specific country.

The United States shows how much the financing matters. It has had a current account deficit in almost every year since the early 1980s, and its net international investment position was about −US$22 trillion in mid-2026. Yet because its debts are in dollars and the dollar is the world’s main reserve currency, foreign investors keep lending, and the deficit has not caused a crisis. A low-income country with the same deficit as a share of GDP, borrowing in dollars, would face a very different risk, as the case of Sri Lanka shows.

Sources: US Bureau of Economic Analysis (2026).

Correcting a persistent current account deficit (HL only)

A government that decides a deficit must be reduced has three groups of policies. Expenditure-switching policies change what people buy; expenditure-reducing policies change how much they buy; supply-side policies change how competitive the economy’s producers are.

Expenditure-switching policies

Expenditure-switching policies aim to switch spending, by both residents and foreigners, away from foreign goods and towards domestically produced goods and services.

• A lower exchange rate. A devaluation of a fixed currency, or a depreciation of a floating or managed one encouraged by lower interest rates or by the central bank selling its currency, makes exports cheaper abroad and imports dearer at home.

• Trade protection. Tariffs and quotas raise the price or limit the quantity of imports; subsidies to domestic producers help them compete with imports and sell abroad.

Both work through relative prices. A 10% depreciation lowers the foreign-currency price of exports and raises the domestic-currency price of imports, so both foreign and domestic buyers switch towards the country’s goods. A tariff raises the price of imports only, so it switches domestic spending but does nothing directly for exports.

Evaluating expenditure switching

• Elasticities. A depreciation improves the current account only if demand for exports and imports is sufficiently price elastic (the Marshall–Lerner condition), and in the short run it often makes the deficit worse (the J-curve).

• Inflation. Dearer imports raise the cost of living and of imported raw materials and components. If wages then rise, domestic costs rise and the competitive gain from the depreciation is gradually lost.

• Retaliation and rules. Tariffs and quotas break World Trade Organization commitments unless they are justified under its rules, and trading partners may respond with retaliation, cutting the country’s exports.

• Efficiency. Protection shields inefficient domestic firms from competition, raises prices for consumers and, in the long run, can make the economy less competitive, which works against the aim of the policy.

• Limited effect on the overall balance. If saving and investment do not change, a smaller deficit on protected goods tends to be offset elsewhere. The US tariffs introduced from 2025 have not removed the US current account deficit: it was about US$1,177 billion (3.8% of GDP) in 2025, close to its 2024 level, and the quarterly goods deficit reached US$456 billion in the first quarter of 2025, as many firms brought imports forward before the tariffs took effect.

Sources: IMF, World Economic Outlook database (October 2026); US Bureau of Economic Analysis (2026).

Expenditure-reducing policies

Expenditure-reducing policies aim to reduce the deficit by lowering total spending in the economy, part of which is spending on imports.

Higher income taxes reduce disposable income, and higher interest rates raise the cost of borrowing, so households and firms spend less. Because part of every extra unit of spending goes on imports, lower spending means fewer imports. Lower demand also reduces inflationary pressure, which helps the competitiveness of exports over time.

In the left-hand panel, contractionary policy shifts aggregate demand from AD₁ to AD₂. Real GDP falls from Y₁ to Y₂ and the average price level from P₁ to P₂. Imports fall because incomes are lower, and the lower price level makes domestic goods slightly more competitive.

Evaluating expenditure reducing

• The cost is lower output and jobs. The policy works mainly by making residents poorer: real GDP falls and cyclical unemployment rises. It conflicts directly with the objectives of growth and low unemployment.

• Only a small share of the cut falls on imports. If the marginal propensity to import is 0.2, total spending must fall by five units to reduce imports by one unit.

• Higher interest rates can work against the aim. Higher rates attract financial inflows and cause the currency to appreciate, which makes exports dearer and imports cheaper.

• It may be unavoidable. When a country can no longer borrow abroad, spending must fall to match what it earns, whether or not the government chooses the policy. Expenditure reducing is often a condition of IMF loans for this reason.

Supply-side policies

Supply-side policies aim to raise the productive capacity and international competitiveness of the economy, so that its firms can sell more abroad and compete better with imports. Examples are spending on education, training and infrastructure, support for research and development, and market-based reforms such as deregulation and policies that increase labour market flexibility.

In the right-hand panel of the diagram, supply-side policies shift LRAS from LRAS₁ to LRAS₂. Potential output rises and the average price level falls from P₁ to P₂. Higher productivity lowers unit costs, so exports become cheaper and better, and more of domestic demand can be met by domestic firms.

Evaluating supply-side policies

• They address the cause when the deficit comes from low competitiveness, and they raise growth at the same time, so they avoid the trade-offs of the other two approaches.

• Long time lags. Education, infrastructure and research take years, often decades, to raise productivity. They cannot deal with a deficit that needs financing now.

• Uncertain effect. Higher productivity may raise incomes and so spending on imports as well as exports, and success depends on what other countries do.

• Costs. Interventionist supply-side policies require government spending, which may be hard to fund for a country already short of foreign currency; market-based ones can raise inequality.

Which method works best?

In practice, governments combine them. A typical package for a country in crisis is a devaluation (to switch spending), contractionary fiscal and monetary policy (to reduce spending and stop the devaluation from causing high inflation), and supply-side reforms (to make the improvement last). The best mix depends on the cause of the deficit: a deficit caused by an overvalued currency calls for a lower exchange rate, one caused by excess demand for expenditure reducing, and one caused by low productivity for supply-side policies.

The Marshall–Lerner condition and the J-curve (HL only)

A depreciation has two effects on the trade balance that pull in opposite directions. The volume effect is favourable: exports become cheaper for foreigners, so more are sold, and imports become dearer at home, so fewer are bought. The price effect is unfavourable: each unit of imports now costs more in domestic currency, so even an unchanged quantity of imports costs more. Whether the trade balance improves depends on which effect is larger, which depends on the price elasticity of demand for exports and for imports.

The Marshall–Lerner condition

If demand for exports and imports is price inelastic, quantities change little when prices change. Foreigners buy only a few more exports, residents buy only slightly fewer imports, and the higher domestic-currency price of the imports they still buy outweighs the gains. The trade balance gets worse. If demand is elastic enough that the two elasticities add up to more than one, the volume effect outweighs the price effect and the trade balance improves.

The PEDs are used as absolute values (without their minus signs). Strictly, the condition in this simple form applies when trade starts in balance and supply is perfectly elastic, but it is the standard test used for any depreciation.

The J-curve

Demand for exports and imports is usually less elastic in the short run than in the long run. Immediately after a depreciation, firms and households keep buying under existing contracts, take time to find new suppliers, and keep their habits; foreign buyers may not yet know that the country’s goods have become cheaper; and exporters may not be able to raise output quickly. Over months and years, buyers switch, exporters expand capacity and new markets open, so the elasticities rise.

The diagram shows the current account balance against time. Before the depreciation the country has a deficit. After the depreciation at A, the price effect dominates and the balance falls to B. As the elasticities rise and the sum of PEDs exceeds one, the volume effect dominates and the balance rises, passing its original level at C. The shape gives the J-curve its name.

Evaluating the effect of a depreciation

• The elasticities vary. Countries that export manufactures and services with close substitutes tend to face more elastic demand than countries that export a few primary commodities or that rely on imported fuel, food and medicines, whose demand is very price inelastic.

• The improvement can be eroded by inflation. Dearer imports raise costs and wages; if domestic prices rise by as much as the currency fell, the competitive gain disappears.

• Other things change. Growth abroad, commodity prices and income flows often move the current account more than the exchange rate does.

The UK after 2016 shows these limits. Sterling depreciated sharply after the referendum on leaving the EU in June 2016. The current account deficit narrowed from 5.1% of GDP in 2016 to 3.3% in 2017, but most of the change came from the income balance, not from trade. The trade deficit in goods and services fell only from US$51 billion to US$36 billion and then stayed at around 1.2% of GDP in 2017–2019, a modest improvement for a large depreciation.

Sources: IMF, World Economic Outlook database (October 2026); World Bank, World Development Indicators, BN.GSR.GNFS.CD, BN.GSR.FCTY.CD and NE.RSB.GNFS.ZS (2026).

Persistent current account surpluses (HL only)

A current account surplus might look like a sign of success, and a strong export sector often is. A large surplus that lasts for many years has costs too, both for the country and for its trading partners, whose deficits are the other side of it.

Why persistent surpluses arise

• High national saving. Germany and China have high saving rates: households, firms and (in Germany) the government save much more than the country invests, and the extra saving is lent abroad.

• Competitive export industries with strong demand for their products, such as German machinery and cars or Chinese electronics.

• An undervalued currency, held below its market level by central bank intervention, or (for Germany) a shared currency, the euro, that is weaker than a German currency would be.

• Exports of natural resources, as for Norway, Saudi Arabia and Qatar, especially when commodity prices are high.

In 2025, China’s current account surplus was estimated at about US$724 billion (3.7% of GDP), and Germany’s at about 4.5% of GDP, after a decade in which Germany’s surplus was often above 7%.

Sources: IMF, World Economic Outlook database (October 2026).

Implications of a persistent current account surplus

Domestic consumption and investment

A surplus means the country produces more than it uses: part of its output is sent abroad and the earnings are lent or invested there. Households consume less than they could, and less is invested at home than the country saves. Critics argue that German households and Chinese consumers have had lower living standards than their incomes allow, and that more domestic investment, in infrastructure in Germany or in public services in China, would raise economic well-being.

Exchange rates

A surplus creates excess demand for the currency, so in a floating system the currency tends to appreciate. If the central bank wants to keep the currency from rising, it must sell its own currency and buy foreign currency, adding to its reserves.

The diagram shows how a managed exchange rate keeps the currency undervalued. At e₁, export demand for the yuan exceeds the supply of yuan for imports. The People’s Bank of China can hold the rate at e₁ only by supplying the extra yuan itself, shown by the shift from S¥₁ to S¥₂, and buying foreign currency, which adds to its reserves. Trading partners, especially the United States, have often accused China of keeping the yuan undervalued in this way.

Inflation

Export demand is part of aggregate demand, so a large and growing surplus adds to AD and can cause demand-pull inflation if the economy is near full capacity. If the central bank prevents appreciation by creating its own currency to buy foreign currency, the money supply grows, which adds to the inflationary pressure. An appreciation, if it is allowed, has the opposite effect: cheaper imports lower inflation.

Employment

Export industries create jobs, and the surplus supports employment in manufacturing. The jobs depend on demand abroad, however. A recession in trading partners, new tariffs or an appreciation can cause large job losses, so an economy that relies on its surplus is exposed to shocks from outside.

Export competitiveness

If the surplus causes the currency to appreciate, exports become dearer for foreign buyers and imports cheaper at home, so export competitiveness falls over time. Firms then need to raise productivity or quality to keep their markets. Persistent surpluses also cause tension with trading partners: because the world’s current accounts sum to zero, one country’s surplus is another’s deficit, and countries with deficits may respond with tariffs and other protection, as the US–China trade conflict since 2018 shows.

Is a persistent surplus a problem?

For an economy with an ageing population, such as Germany, saving now and investing abroad can be a sensible way to provide for future pensions, and a surplus earned by an oil exporter can turn a depleting natural resource into a lasting stock of foreign assets, as Norway’s fund does. A surplus caused by weak domestic demand, an undervalued currency and low wages, on the other hand, holds down living standards at home and adds to imbalances abroad. As with deficits, the judgment depends on the cause and on what the country does with the surplus.

Key concepts in the balance of payments

These concepts are closely linked. Change in the exchange rate is a form of adjustment, and when intervention blocks it, the pressure shows up elsewhere, in reserves, interest rates or debt.

Case study: Sri Lanka’s balance of payments crisis, 2019–2024

Sri Lanka ran a current account deficit in every year from 2012 to 2022, typically between 1.4% and 5.7% of GDP. Like many middle-income economies, it financed these deficits largely by borrowing abroad in US dollars, including through international sovereign bonds, and it managed its exchange rate against the dollar. Its foreign currency earnings came mainly from exports of clothing and tea, from tourism and from remittances sent by Sri Lankans working abroad.

What happened

Several shocks hit the current account and the financial account at once. Tourism receipts fell from US$5.6 billion in 2018 to US$4.7 billion in 2019, after the Easter Sunday bombings in April 2019, and then to US$1.1 billion in 2020 as COVID-19 closed borders. In late 2019 the government cut taxes sharply, reducing the VAT rate to 8% and the corporate tax rate from 28% to 24%, which widened the budget deficit.

Credit rating agencies downgraded Sri Lanka, which made it much harder and more expensive to borrow on international bond markets. In April 2021 the government banned imported chemical fertiliser; farm output fell and rice had to be imported before the ban was abandoned in November 2021.

With export earnings down and foreign lending drying up, the central bank used its reserves to pay for imports and debt service and to hold the rupee at about 200 per dollar. Total reserves fell from US$7.6 billion at the end of 2019 to US$3.1 billion at the end of 2021.

The chart shows reserves being run down to defend the exchange rate and pay for imports, and rebuilt only after the crisis.

In March 2022 the central bank let the rupee fall: the official rate moved to about Rs 230 per dollar on 7 March and about Rs 355 by early April. On 12 April 2022 the government announced that it would suspend payments on its external debt of about US$51 billion. Fuel and medicines ran short, power cuts reached 15 hours a day, and mass protests led the president to resign in July 2022.

The table sets the reserves beside the other main indicators, showing how the currency, prices and output moved as the reserves ran out.

Sources: World Bank, World Development Indicators: BN.CAB.XOKA.GD.ZS, FI.RES.TOTL.CD, PA.NUS.FCRF, FP.CPI.TOTL.ZG, NY.GDP.MKTP.KD.ZG, ST.INT.RCPT.CD (2026).

What the theory explains

Sri Lanka shows the balance of payments identity under strain. A current account deficit must be matched by financial account inflows or by a fall in reserves. When the downgrades and the pandemic stopped new borrowing (a financial account sudden stop), the deficit could be financed only from reserves, so reserves fell year after year. Holding the rupee near 200 per dollar made the problem worse: it kept imports cheap and drained reserves faster, as in a fixed exchange rate under pressure.

When the reserves ran out, adjustment was forced. On yearly averages, a US dollar cost about 62% more rupees in 2022 than in 2021 (the rupee lost about 38% of its value), an expenditure-switching shock that the government no longer controlled. Because many of Sri Lanka’s imports were essentials such as fuel, food and medicines, demand for them was very price inelastic, so the depreciation raised their rupee cost sharply and fed straight into inflation of almost 50% in 2022. The current account deficit narrowed in 2022 largely because the country could not pay for imports, which is expenditure reducing at its most painful: real GDP fell by 7.3%.

Most of the implications of a persistent deficit appeared at the same time, as the table shows.

In March 2023 the IMF approved a loan of about US$3 billion under an Extended Fund Facility, a form of official borrowing, with conditions that included large tax increases: the VAT rate, cut to 8% in 2019, was raised in steps to 18%. By 2023 the current account was in surplus, reserves had begun to recover and inflation fell, turning slightly negative in 2024; growth returned at about 5% in 2024 and 2025.

What the case shows, and its limits

The case shows that the danger of a current account deficit depends less on its size than on how it is financed. Sri Lanka’s deficits were not unusually large as a share of GDP, smaller than the UK’s in some years, yet they ended in default, because they were financed by foreign-currency borrowing, reserves were small and confidence was lost. The United States runs deficits of similar or larger size relative to GDP with no such risk, because it borrows in its own currency.

The case has limits as evidence. The crisis was also a fiscal crisis, driven by tax cuts and a large budget deficit, and a policy crisis, made worse by the fertiliser ban; the balance of payments was where these problems became visible.

Sri Lanka’s recovery also shows that adjustment can be quick once financing returns, though the cost fell heavily on households through inflation and lost incomes. The 2026 oil price shock is a new test: Brent crude averaged about US$71 a barrel in February 2026 and US$117 in April, and IMF projections published in October 2026 show Sri Lanka’s current account moving from a surplus of 1.6% of GDP in 2025 to a small deficit in 2026.

Sources: World Bank, WDI (2026); IMF, World Economic Outlook database (October 2026); Federal Reserve Bank of St Louis, FRED, MCOILBRENTEU (2026); Wikipedia, “Sri Lankan economic crisis (2019–present)”, citing the Central Bank of Sri Lanka and IMF (accessed 2026).

Exam practice

The balance of payments appears in every paper. Paper 2 often gives balance of payments data for a country and asks you to define an account [2] or calculate a balance or a missing item [2–3]. Paper 1 questions at SL ask you to explain the structure of the accounts and how they are linked; HL Paper 1 and Paper 3 add the exchange rate links, persistent deficits and surpluses, policies to correct a deficit and the Marshall–Lerner condition with the J-curve.

Data questions often give the capital and financial accounts as well and ask for a missing figure, as in the Country B example; the method is the identity, with an increase in reserve assets entered as a debit.

Paper 2 can also link balance of payments data to the SL exchange rate diagram, for example: “Using an exchange rate diagram, explain how a fall in tourism revenue could cause the rupee to depreciate [4].” The answer shows a leftward shift of the demand for rupees (fewer foreign tourists buying rupees), a lower exchange rate, and two or three sentences linking the shift to the text.

Paper 3 part (b) may then ask you to recommend a policy to reduce a persistent current account deficit [10]. A strong recommendation names one main policy, explains how it works with theory and the case’s data (the elasticities, the size of the deficit, inflation, unemployment), weighs its costs and an alternative, and ends with a clear recommendation, for example a managed depreciation with supply-side measures if the Marshall–Lerner condition holds and inflation is low.

Summary

• The balance of payments records all transactions between a country’s residents and the rest of the world; money flowing in is a credit (+), money flowing out a debit (−).

• The current account covers trade in goods, trade in services, income and current transfers; the capital account covers capital transfers and non-produced, non-financial assets; the financial account covers FDI, portfolio investment, reserve assets and official borrowing.

• The balance of payments always sums to zero: a current account deficit is matched by a surplus on the capital and financial accounts, with net errors and omissions closing any gap.

• HL: current account flows and financial account flows both drive the demand for and supply of a currency, so the accounts and the exchange rate affect each other.

• HL: a persistent deficit can put pressure on the exchange rate, raise interest rates, increase foreign ownership and debt, lower credit ratings and constrain policy; how serious it is depends on its size, cause and financing.

• HL: a deficit can be reduced by expenditure switching, expenditure reducing or supply-side policies, each with trade-offs and time lags.

• HL: a depreciation improves the current account only if PEDx + PEDm > 1 (Marshall–Lerner), and usually worsens it first (the J-curve).

• HL: a persistent surplus can hold down domestic consumption and investment, cause appreciation and inflationary pressure, support export jobs and create tension with trading partners.

Self-check

• To do:

  I can define the balance of payments and classify any transaction as a credit or a debit.

• To do:

  I can describe the components of the current, capital and financial accounts.

• To do:

  I can calculate the balance on each account and a missing item, such as net errors and omissions, from data.

• To do:

  I can explain why the balance of payments always sums to zero and why a current account deficit is matched by a surplus elsewhere.

• To do:

  I can draw and explain an exchange rate diagram linking the current account and financial account to the exchange rate (HL).

• To do:

  I can evaluate the implications of a persistent current account deficit and of a persistent surplus, using real examples (HL).

• To do:

  I can evaluate expenditure-switching, expenditure-reducing and supply-side policies to correct a deficit (HL).

• To do:

  I can state the Marshall–Lerner condition, use it in a calculation and draw the J-curve (HL).

Table 2: Selvara's current account, 2024 (US$ million)

Text B — The cotton economy

[1] Around 900 000 farm households grow cotton, which provides about 40 % of Selvara's earnings from goods exports. Almost all of it is exported as raw lint to spinning mills in Asia.

[2] In 2024, large harvests in the major producing countries and the growing use of synthetic fibres by clothing makers pushed the world price of cotton lint down from US$1.90 to US$1.52 per kg. Selvara's cotton export volume rose from 300 million kg to 315 million kg.

[3] Cotton farmers' incomes fell, and many families withdrew their children from secondary school. The farmers' association says that, because demand for raw cotton is price inelastic, good harvests around the world hurt farmers.

[4] The government hopes to attract investors to build spinning mills and garment factories, so that more of the value of cotton is added in Selvara. However, electricity supply is unreliable, transport costs to the nearest seaport are high, and few workers have technical skills. Selvara's garments would compete with exports from well-established Asian producers. Selvara does, however, have duty-free access for garments to several high-income markets under preferential trade schemes, and wage costs are among the lowest in the region.

[5] Some farmers have started to grow organic cotton, which sells for a premium of about 25 % over conventional cotton, although yields are lower and certification is expensive.

Text C — A growing urban middle class

[1] In the capital, a growing middle class works in banking, telecommunications and government. In 2024 average urban household income rose by 7 % in real terms, while average rural household income fell by 3 %.

[2] Urban households are spending more on restaurant meals, private schooling, mobile data and travel, all of which have income elastic demand. Restaurant owners report that their prices are rising quickly because the number of restaurants has not kept up with demand.

[3] Demand for maize flour, the staple food of poorer households, has hardly changed in the cities. Several mobile banking firms have expanded into rural areas, making it cheaper for families to receive remittances.

[4] The government's new development plan aims to raise the share of manufacturing in GDP from 8 % to 15 % by 2035 and to connect every district town to the national electricity grid. Critics point out that spending on rural roads and agricultural extension services has been cut to pay for the plan.

1. (a)(i)

   Define the term cost-push inflation indicated in bold in the text (Text A, paragraph 2).

   [2]2 marks

   Markscheme (a)(i)

   Vague definition [1]: The idea that it is inflation caused by higher costs.

   Accurate definition [2]: An understanding that it is a sustained increase in the average (general) price level caused by an increase in costs of production (such as wages or the prices of imported raw materials and energy), shown as a leftward shift of SRAS.

2. (a)(ii)

   Define the term income elastic indicated in bold in the text (Text C, paragraph 2).

   [2]2 marks

   Markscheme (a)(ii)

   Vague definition [1]: The idea that demand changes a lot when income changes.

   Accurate definition [2]: An understanding that demand is income elastic when a change in income leads to a proportionately larger change in quantity demanded / YED is greater than 1.

3. (b)(i)

   Using information from Text B, calculate the price elasticity of demand for Selvara's cotton exports (Text B, paragraph 2).

   [2]2 marks

   Markscheme (b)(i)

   $$\%\Delta P = \frac{1.52 - 1.90}{1.90} \times 100 = -20\%$$

   $$\%\Delta Q_d = \frac{315 - 300}{300} \times 100 = 5\%$$

   $$PED = \frac{5}{-20} = -0.25$$

   [1] for valid working, [1] for the correct answer. Accept −0.25 or 0.25.

   An answer of 0.25 without working is sufficient for [1]. A response in which the formula is inverted should be awarded [0]. A response expressed as a percentage is a units error.

4. (b)(ii)

   Using your answer to (b)(i), state whether Selvara's export revenue from cotton rose or fell in 2024.

   [1]1 mark

   Markscheme (b)(ii)

   Fell, because demand is price inelastic (the percentage rise in quantity is smaller than the percentage fall in price) [1].

   (Revenue fell from US$570 million to US$478.8 million.)

   OFR applies. Working not required.

5. (b)(iii)

   Using information from Table 2, calculate Selvara's current account balance in 2024.

   [2]2 marks

   Markscheme (b)(iii)

   $$1200 - 2870 - 380 - 210 + 1260 = -1000$$

   Current account balance = −US$1000 million (a deficit of US$1 billion).

   [1] for valid working, [1] for the correct answer, which must show a deficit/negative value.

   An answer of −1000 without working is sufficient for [1]. Award [1] if one item is omitted or has the wrong sign but the working is otherwise correct.

6. (c)

   Using an aggregate demand/aggregate supply (AD/AS) diagram, explain how higher prices of imported fuel and fertilizer contributed to higher inflation in Selvara (Text A, paragraph 2).

   [4]4 marks

   Markscheme (c)

   Level 1 [1–2]: There is a correct diagram OR an accurate written response.

   Level 2 [3–4]: There is a correct diagram AND an accurate written response.

   For Level 2, responses should include:

   • Diagram: SRAS shifting left from SRAS1 to SRAS2, showing the average price level rising from P1 to P2 and real output falling from Y1 to Y2.

   • Explanation: the depreciation of the shilling (from SVS 108 to SVS 126 per US$) raised the shilling price of imported fuel and fertilizer; these are important inputs for farmers, transport and industry, so costs of production rose and SRAS fell; the result is a higher average price level (inflation rose from 4.0 % to 9.6 %) and lower real output.

   Candidates who incorrectly label diagrams can be awarded a maximum of [3].

   Vertical axis: average price level/price level/CPI; horizontal axis: real output/real GDP/real national income.

7. (d)

   Using an exchange rate diagram, explain how the fall in the world price of cotton may have contributed to the depreciation of the Selvaran shilling (Text A, paragraph 2 and Text B, paragraph 2).

   [4]4 marks

   Markscheme (d)

   Level 1 [1–2]: There is a correct diagram OR an accurate written response.

   Level 2 [3–4]: There is a correct diagram AND an accurate written response.

   For Level 2, responses should include:

   • Diagram: a foreign exchange market for SVS with demand for SVS shifting left from D1 to D2, showing the exchange rate (US$ per SVS) falling from ER1 to ER2.

   • Explanation: foreign buyers of cotton must buy shillings to pay Selvaran exporters (or exporters convert their US$ earnings into shillings); because demand for cotton is price inelastic, the lower world price reduced export revenue (part (b)(ii)), so fewer US dollars were converted into shillings; lower demand for the shilling caused it to depreciate.

   Candidates who incorrectly label diagrams can be awarded a maximum of [3].

   Vertical axis: exchange rate/price of SVS in US$/US$ per SVS; horizontal axis: quantity of SVS.

8. (e)

   Using a demand and supply diagram, explain the effect of rising urban incomes on the price of restaurant meals in Selvara's capital (Text C, paragraphs 1 and 2).

   [4]4 marks

   Markscheme (e)

   Level 1 [1–2]: There is a correct diagram OR an accurate written response.

   Level 2 [3–4]: There is a correct diagram AND an accurate written response.

   For Level 2, responses should include:

   • Diagram: a demand and supply diagram for restaurant meals with demand shifting right from D1 to D2 and a relatively steep (inelastic) supply curve, showing the price rising from P1 to P2 and quantity rising from Q1 to Q2.

   • Explanation: urban incomes rose by 7 %; restaurant meals have income elastic demand (YED > 1), so demand rises proportionately more than income; because the number of restaurants has not kept up (supply is relatively inelastic in the short run), the increase in demand leads mainly to a rise in price.

   Candidates who incorrectly label diagrams can be awarded a maximum of [3].

   Vertical axis: price/P; horizontal axis: quantity/Q (of restaurant meals).

9. (f)

   Using a Lorenz curve diagram, explain how the changes in urban and rural incomes in 2024 are likely to affect income inequality in Selvara (Text A, paragraph 4 and Text C, paragraph 1).

   [4]4 marks

   Markscheme (f)

   Level 1 [1–2]: There is a correct diagram OR an accurate written response.

   Level 2 [3–4]: There is a correct diagram AND an accurate written response.

   For Level 2, responses should include:

   • Diagram: a Lorenz curve diagram with the line of equality and the Lorenz curve moving further away from it (from L1 to L2), indicating a higher Gini coefficient.

   • Explanation: most low-income households live in rural areas and depend on cotton and other farming; rural incomes fell by 3 % (partly because cotton prices fell), while urban middle-class incomes rose by 7 %; the share of national income received by the poorest groups falls and the share of richer groups rises, so the Lorenz curve moves further from the line of equality and the Gini coefficient rises (as it did from 0.38 to 0.44).

   Candidates who incorrectly label diagrams can be awarded a maximum of [3].

   Vertical axis: cumulative % of income; horizontal axis: cumulative % of population (households).

10. (g)

    Using information from the text/data and your knowledge of economics, discuss the view that Selvara should reduce its dependence on raw cotton exports in order to achieve economic growth and economic development.

    [15]15 marks

    Markscheme (g)

    Discuss requires candidates to offer a considered and balanced review that includes a range of arguments, factors or hypotheses.

    Answers may include:

    • Terminology: economic growth, economic development, primary commodity, diversification, PED, YED, price volatility, value added, comparative advantage, infrastructure, human capital, current account deficit.

    • Diagrams: demand and supply with inelastic demand showing a large price fall after a supply increase; exchange rate diagram (part (d)); AD/AS showing growth from investment; PPC shifting outward. N.B. Diagrams given in earlier parts and referred to here should be rewarded.

    • Theory: dependence on a primary commodity with low PED makes export earnings volatile; low YED for many commodities means demand grows slowly as world incomes rise; diversification and processing add value.

    Arguments for reducing dependence:

    • cotton provides 40 % of goods export earnings (Text B, paragraph 1), and with PED of −0.25 a 20 % price fall cut export revenue by 16 % (part (b)), slowing growth from 5.6 % to 3.1 % (Table 1);

    • falling export earnings weakened the shilling (part (d)), raising import prices and inflation to 9.6 % (Text A, paragraph 2);

    • demand for cotton faces long-term competition from synthetic fibres (Text B, paragraph 2);

    • volatile farm incomes damage development: families withdrew children from school (Text B, paragraph 3), and rural incomes fell while urban incomes rose, widening inequality (Text C, paragraph 1);

    • processing cotton into yarn and garments would add value, create manufacturing jobs and reduce the current account deficit of US$1000 million (Table 2);

    • services with income elastic demand (Text C, paragraph 2) are growing and could provide alternative employment.

    Arguments against / limitations:

    • Selvara may have a comparative advantage in cotton; 900 000 households depend on it (Text B, paragraph 1), and diversification takes time and may cause structural unemployment;

Synthesis/evaluation: short run versus long run; stakeholders (cotton farmers, urban workers, the government, foreign investors); the need for investment in infrastructure and human capital before diversification can succeed; a reasoned conclusion.

A maximum of [9] should be awarded if only economic growth or only economic development is discussed.

Examiners should be aware that candidates may take a different approach which, if appropriate, should be rewarded.

Markbands (best fit)

[4]4 marks