IB Docs (2) Team
Balance of payments
Introduction
This lesson looks at balance of payments, which some IB students confuse with the current account. When teaching this lesson I ask my classes to think of a country as their own household income with funds coming in and then going out. If a household spends more than it receives in income then this will reduce the size of an individuals savings or assets. Similarly when a household spends less than the income it receives then their savings / assets will grow. The nations which currently have the largest currency and gold reserves can be found by clicking on the small eye.
Enquiry question
How is the balance of payments calculated?
Lesson time: 1 hour (50 minutes for the SL exercises)
Lesson objectives:
Outline the role of the balance of payments. Distinguish between debit items and credit items in the balance of payments.
Explain the four components of the current account, specifically the balance of trade in goods, the balance of trade in services, income and current transfers.
Calculate elements of the balance of payments from a set of data. (HL only)
Explain that the current account balance is equal to the sum of the capital account and financial account balances. Distinguish between a current account deficit and a current account surplus.
Explain the two components of the capital account, specifically capital transfers and transaction in non-produced, non-financial assets.
Explain the three main components of the financial account, specifically, direct investment, portfolio investment and reserve assets. Examine how the current account and the financial account are interdependent.
Teacher notes:
1. Beginning activity - begin with the opening presentation and then discuss this as a class. (Allow 10 minutes in total)
2. Processes - technical vocabulary - the students can learn the background information from the videos and the handouts, including the key terms and 'Balance of payments components' handout. (15 minutes)
3. Applying the theory - Use the handout to complete activities 1 - 3. Activity 1 is HL only. (20 minutes)
4. Investigation question - which nation possesses the largest foreign and gold currency reserves? (5 minutes)
5. Paper two type question (parts a-c) only - this can also be set as a homework exercise. (10 minutes if set in class)
Key terms:
Balance of payments - includes the balance of trade in goods, the balance of trade in services, (investment or factor) income (interest, dividends, profit), and (current or net) transfers. This could be referred to as “exports of goods and services” 
and “imports of goods and services” but cannot be referred to as simply imports and exports.
Current account (balance) is a record of the revenues earned from the export of goods and services and the expenditure on imports of goods and services.
Current account deficit is where the value of total imports of goods and services plus net income flows are greater than the value of total exports of goods and services.
Current account surplus is where revenues from the exports of goods and services plus net income flows are greater than the spending on the imports of goods and services.
Credit - any transaction that results in currency coming into the country. Credit items are awarded a positive value on the balance of payments.
Debit - any international transaction which results in money leaving the nation. Debit items are awarded a negative value on the balance of payments.
Balancing item - the difference between debits and credits. It is the amount that a country requires in order to make their debits and credits balance.
Visible trade balance - measures the trade in physical goods.
Invisible trade balance - measures the trade in services.
Net factor income from abroad - the difference between income earned from abroad by normal residents of a country (from rent, interest, wages e.t.c.) and the income earned by non-residents (foreigners) in that country.
Current transfers - transfers of money between countries for non-investment purposes e.g. a payment by the British government in the form of AID or a parent sending their child living expenses when studying overseas.
Capital account - the transfers of money, into and out of a country for investment purposes and is divided into capital transfers and transactions of intangible non financial assets e.g. the international purchase of patents, copyrights, franchises or rights to natural resources.
Financial account - this measures the net change in ownership of financial assets and consists of a record of the number of domestic assets purchased by overseas purchasers, as well as foreign assets purchased by domestic residents.
The activities on this page are available at: 
Balance of payments
Opening activity
Watch the following short video before completing the activities which follow.
Balance of payments components
An example of some of the items which go into a balance of payments for a country.
Credits (foreign currency coming into the country) | Debits (foreign currency leaving the country) |
Current account (trade in goods and services) | |
A - Exports of goods (visible exports) | E - Imports of goods (visible imports) |
B - Exports of services (invisible exports) Domestic sales of financial services, films, music e.t.c Spending by tourists overseas Foreign students entering home universities | F - Imports of services (invisible imports) Domestic purchases of financial services, films, music e.t.c Spending by tourists overseas Students studying in overseas colleges |
C - Investment income entering into the country Profits from home firms based overseas and returned to the country of origin | G - Investment income leaving the country Profits from foreign firms based in the home country that are returned overseas |
D - Unilateral transfers of funds into the country Remittances to families from expatriates living overseas | H - Unilateral transfers of funds leaving the country Remittances to families, based overseas, from expatriates living in the country |
Current account balance (A+B+C+D) – (E+F+G+H) | |
Capital account | |
I - Capital transfers into the country | J- Capital transfers out of the country |
| Financial account | |
K - Investment incomes entering the country Foreign businesses setting up in the country Shares in domestic businesses purchased by foreign citizens Hot money flows into domestic banks Funds lent to overseas institutions | L- Investment income leaving the country Businesses set up by the country's citizens overseas Shares in foreign businesses purchased by domestic citizens Capital flight (this is particularly significant in LEDCs) Funds borrowed from overseas institutions |
Balancing item (A+B+C+D+I+K) – (E+F+G+H+J+L) | |
0 | 0 |
Activity 1 (HL only exercise)
Using the table, which illustrates the balance of payment for the UK in 2015, to answer the following question:
Why do you believe that the UK has a significant deficit in visible trade but a significant (although smaller) surplus in invisible trade?
| Item | Billion UK £ |
| Export of goods | 285,524 |
| Export of services | 226,023 |
| Total export of goods and services | 511,547 |
Import of goods | 410,874 |
| Import of services | 137,346 |
| Total imports of goods and services | 548,220 |
| Current account balance | (36,673) |
| Capital and financial account balance | (1,101) |
| Balancing item | 37,774 |
The UK is an example of a nation that has de-industrialised moving from a once large manufacturing base towards a much smaller one. As a result of high labour costs and lower productivity than the G7 average, UK manufacturers have found it difficult to export their goods overseas, exporting less than some smaller European nations such as Holland. Labour intensive manufacturing has fallen by the largest amount. By contrast the UK has a thriving financial sector which is the world's third largest in terms of output. Britain has been successful at exporting financial services overseas. Repatriated profit is also part of the current account and this too will have made a contribution to the UK's service exports.
Activity 2
State the impact of the following on the UK's balance of payments:
1. UK tourists visiting the USA on vacation.
This would be a debit to the UK on the current account.
2. A retired British couple set up a bar in southern Spain.
This would be a debit to the UK on the financial account. If the bar makes a profit in the future and the profits are repatriated to the UK then this would represent a credit on the UK current account.
3. A foreign student gains entry to a university in the UK.
This would be a credit on the UK's current account.
4. An American business makes a profit from its UK subsidiary.
A debit on the UK current account as the profits are repatriated back to the USA.
5. A British teacher working in China sends a portion of their salary back to their family in the UK.
A credit on the current account.
6. A Japanese businessman places their savings in a UK bank account in order to take advantage of higher interest rates in the UK.
A credit on the UK financial account.
7. UK consumers purchasing fashion items imported from overseas.
A debit on the current account.
Activity 3: Reinforcement questions
(a) Why must the balance of payments balance?
When a nation receives a payment e.g. exports sales or a capital balance then this is recorded as a credit. The credit will be in foreign currency and so adds to the nations reserves. When the same nation pays for an international transaction e.g. a foreign aid donation or an imported good or service, then some of that foreign currency is debited from the nation's reserves. Like all accounting systems the nation's assets (credits) and liabilities (debits) should balance.
(b) Explain the difference between the visible and invisible trade balance?
The visible trade balance measures the trade in physical goods while the invisible trade balance measures the trade in services.
(c) State the four components of the current account.
The balance of trade in goods, the balance of trade in services, income and current transfers.
(d) Explain the two components of the capital account, capital transfers and transactions of non-produced, non-financial assets.
Transfers are payments not made in exchange for a direct good or service. A capital transfer is one designed to produce investment income, while non-produced, non-financial assets include things like patent rights and debt forgiveness. All of this has to be recorded in the balance of payments.
(e) Explain how each of the following would be recorded of a nation's balance of payments. All examples relate to the UK balance of payments.
i. HSBC sets up a subsidiary overseas.
Debit on the financial account
ii.HSBC shareholders receive a dividend from their overseas subsidiary.
Credit (investment income) - part of the current account
iii. An Indian student completes a university course in London.
Credit (invisible earning on the current account)
iv. The UK pays its annual budget contribution to the EU / UN.
Debit (current transfer)
v. A British worker, living in Singapore, receives their salary in a UK bank account.
Credit (current transfer)
vi. A Chinese citizen purchases property in London.
Credit (capital transfer)
Activity 4: Investigation
Which nations currently hold the largest financial currency reserves?
| Nation | Size of reserves (M$s) | Date |
| China | 3,373,016 | September 2021 |
| Japan | 1,409,309 | September 2021 |
| Switzerland | 1,087,774 | August 2021 |
| India | 640, 874 | November 2021 |
| Russia | 622, 100 | November 2021 |
| Taiwan | 544, 900 | September 2021 |
| Hong Kong | 497,000 | August 2021 |
| South Korea | 464,000 | September 2021 |
| Saudi Arabia | 454, 498 | August 2021 |
| Singapore | 418, 146 | August 2021 |
| Brazil | 370,395 | August 2021 |
| Germany | 296, 727 | August 2021 |
| Thailand | 282, 172 | August 2021 |
| USA | 251, 238 | October 2021 |
| France | 244, 401 | August 2021 |
| UK | 229, 943 | September 2021 |
| Italy | 226, 908 | August 2021 |
| Mexico | 211, 670 | August 2021 |
| Israel | 207, 473 | October 2021 |
A full list of nations reserves can be found at: Reserves
Activity 5: Link to the assessment
Examples of typical paper two examination questions (a - c) only.
(a) Define the following terms:
i. current account [2 marks]
A record of the flow of funds, into and out of the country, resulting from when a nation trades in goods and services (i.e. exports minus imports), net flows of income which includes monies received from profits, interest, wages and rents, plus other net transfers of funds e.g. foreign aid, grants and pensions.
ii. financial account [2 marks]
A measure of the capital flows into and out of the country, both short term and long term. It includes items such as net direct investment, net portfolio investment and a nation's reserve assets.
b. Explain how direct foreign investment and income from investment are recorded in a nation's balance of payments. [4 marks]
FDI involving the purchase of overseas assets is recorded in the financial account, while the income earned from that investment is recorded in a nation's current account.
c. Explain the likely impact on a nation's financial account when a current account goes into deficit. [4 marks]
Presuming that this is the only change in the capital account a deficit on the current account will cause a surplus on the (capital + financial account). This may be the result of the central bank making up for the shortfall by using its foreign currency reserves, borrowing from overseas or the sale of domestic assets, such as property or shares to overseas buyers.
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