4.1.7 Balance of Payments — Practice Questions

Five original multiple-choice questions on the balance of payments, written to the style and difficulty of Edexcel Paper 2 Section A.

5 questions Edexcel A-Level Multiple choice Model answers included

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5 questions in this set

  1. 1. Migrant workers in a country send part of their earnings home to their families abroad. In that country's balance of payments these payments are recorded in the

    Definition in context

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    Answer: C (Current account, as secondary income.). The current account has four components, and the last two are easily confused. Primary income is the return earned on factors of production — profits, interest and dividends. Secondary income is transfers for which nothing is received in return: foreign aid, gifts, and remittances sent home by workers. Nothing is being paid for here, and that is what places remittances in secondary income.

    Why the other options are wrong

    • A — The capital account records transfers of fixed assets and debt forgiveness, not income sent abroad.
    • B — Primary income would be right if the payment were a return on an investment. Wages sent to relatives are not.
    • D — Portfolio investment is the purchase of foreign shares and bonds — an entry in the financial account.

  2. 2. A country cancels a debt owed to it by a lower-income country. In its balance of payments this is recorded in the

    Definition in context

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    Answer: A (Capital account.). The capital account is the smallest of the three and records a narrow set of items: transfers of ownership of fixed assets such as land and buildings, and debt forgiveness. Writing off a loan hands over the value of an asset with nothing coming back, which is why it sits here rather than in the financial account, where the original lending was recorded.

    Why the other options are wrong

    • B — The current account records trade, income and transfers of money. Cancelling a debt transfers an asset.
    • C — The financial account records investment flows and changes in reserves. Cancelling a debt is not an investment.
    • D — There is no separate reserve account. Reserve assets sit inside the financial account.

  3. 3. One foreign investor buys £5m of shares in a listed company but takes no part in running it; another buys a factory and operates it. In the financial account these are respectively

    Applied reasoning

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    Answer: B (Portfolio investment and FDI.). Both are entries in the financial account, and the distinction is control. Portfolio investment buys financial assets — shares and bonds — purely for the return, with no involvement in management. Foreign direct investment buys physical assets abroad with the intention of operating them. FDI tends to be long-term and hard to reverse; portfolio investment can be sold in a day, which is why an economy financed by one is in a very different position from one financed by the other.

    Why the other options are wrong

    • A — The order is reversed. Buying shares passively is portfolio investment; operating a factory is direct investment.
    • C — Primary and secondary income are current account components, not investment flows.
    • D — Reserve assets are a central bank's foreign currency holdings, and capital transfers belong to the capital account.

  4. 4. Two countries run current account deficits of exactly the same size. One is financed by long-term foreign direct investment; the other by short-term deposits that can be withdrawn at any time. The second country is more vulnerable because

    Applied reasoning

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    Answer: C (The funding can leave at short notice.). The balance of payments always balances, so both deficits are being financed — the question is by what. FDI buys factories and equipment that cannot be moved out quickly, and the investor's return depends on the economy performing. Short-term deposits can be withdrawn the moment sentiment turns, and if they are, the currency falls sharply and the deficit has to close abruptly rather than gradually. The size of a deficit matters less than the quality of what finances it.

    Why the other options are wrong

    • A — The stem states that the two deficits are the same size, so this cannot be the difference.
    • B — A current account deficit is matched by a surplus on the capital and financial accounts, and that holds for both countries equally.
    • D — The currency of repayment is a genuine risk, but the distinction the stem draws is the term of the funding rather than its denomination.

  5. 5. Table 1 lists four international transactions recorded by one country.
    From Table 1, the only one entered in the current account as primary income is

    Data interpretation

    Table 1: Four international transactions recorded by one country
    Transaction
    Transaction 1 Aid is sent to a country after an earthquake
    Transaction 2 A foreign firm builds a factory in the country
    Transaction 3 The central bank's foreign currency holdings fall
    Transaction 4 A resident receives dividends from foreign shares
    Select one answer
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    Answer: D (Transaction 4.). Primary income is the return earned on factors of production owned abroad — profits, interest and dividends. Transaction 4 is exactly that: a payment received for owning a foreign asset. The other three sit elsewhere in the accounts.

    Why the other options are wrong

    • A — Aid is a transfer for which nothing is received in return, which makes it secondary income.
    • B — Building a factory abroad is foreign direct investment, an entry in the financial account.
    • C — Changes in the central bank's foreign currency holdings are reserve assets, also in the financial account.

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