The balacne of payments is a record of payments between one country and the rest of the world. The most significant element of it for your AS exam is the current account, which records trade in goods, trade in services, investment income and transfers. A country such as Germany, which exports a large number of high value goods has a surplus on the current account, meaning that more money flows in via exports than flows out for imports. On the other hand, a country that enjoys a high standard of living and a high confidence level, and which is not as successul in export markets, is likely to be running a current account deficit where outflows are greater than inflows. Examples are the USA, Spain and the UK.
On its own, a balance of payments deficit on current account is not a problem for an economy as long as it can be funded, but it becomes a problem if reserves of foreign currencies begin to run low. It might mean that the the currency falls in value, which is inflationary (imports become more expensive). It might be a sign that the country is becoming uncompetitive (costs rising relative to trading partners) and might in the long run mean painful readjustment, such as tax increases, required to stop people overspending.
Trade in goods measures the movement of tangible products across international borders. The UK is a large exporter of pharmaceuticals and cars, but a major importer of foodstuffs and, since 2005, a net importer of oil and gas. Trade in services measures movement of intangible output. THe UK is a major exporter of banking and insurance services, but an importer of foreign holidays (Britons like to go abroad).
Investment income is a masure of interest, profit and dividends that are rewards for capital investments in another country. For example, if a British person buys shares in a US company, the shares will not appear on the current account, but any dividends will appear as a positive figure on the UK current account. FInally transfers refer to the movement of funds for which there is no corresponding trade in goods or services. Examples are taxes paid to the EU, payments to British military personnel working in another country, and when economic migrants send some of their incomes back to their families in other countries.
Causes and costs of an imbalance
The cause of a current account imbalance may be that a country is spending too much, or tat it is not producing anything that potential customers abroad might buy. It may be because of the stage in the business cycle, which clearly may be different for different counties at different times, or the strength of the currency. For example, if sterling is strong against the dollar, the UK is likely to export less and import more, because the price of UK exports rises relative to the world market, and imports become relatively cheap in the UK. Perhaps the most significant factor in the UK is the loss of competitiveness in the manufacturing sector owing to higher cots of factors of production in the UK relative to the Far East. It takes time for economies to adjust to changing comparative costs, and during the adjustment process the UK is likely to face an ongoing deficit.
The costs of a current account imbalance become significant only when the deficit or surplus becomes unsustainable. Sustainability means the needs of the present are met without compromising the ability of future genrations to meet their own needs. Persistent deficits can make the value of a currency fall, so in some economies the government may try to buy up surplus currency in order to maintain its value. (This does not happen in the UK). A fall in the value of currency may restore competitiveness, as it makes imports seem expensive and exports relatively cheap on international markets. Persistant deficits see net incomes leave the country, which might mean demand in the domestic country is subdued. If you are a worker this might mean you loose your job, but from the perspective of the Monetary Policy Committee this is a welcome development as it prevents the onset of inflation.