Subject 4. The Balance of Payments

When we buy something from another country, we use the currency of that country to make the transaction. We record international transactions in the balance of payments accounts.

A country's balance of payments accounts records its international trading, borrowing, and lending.

  • It summarizes the transactions of the country's citizens, businesses, and government with foreigners.
  • Its accounts reflect all payments and liabilities to foreigners (debits) and all payments and obligations received from foreigners (credits).

Balance-of-payments accounts are recorded using the regular bookkeeping method.

  • Any transaction that creates a financial inflow is recorded as a credit. That is, if a country has received money, this is known as a credit. Exports are an example of a credit item.
  • Any transaction that creates a financial outflow is recorded as a debit. That is, if a country has paid or given money, the transaction is counted as a debit. Imports are an example of a debit item.

The main categories of the balance of payments are:

  • Current account

    It records payments for imports of goods and services from abroad, receipts from exports of goods and services sold abroad, net interest paid abroad, and net transfers (such as foreign aid payments).

    When combined, goods and services together make up a country's balance of trade (BOT). The BOT is typically the biggest bulk of a country's balance of payments as it makes up total imports and exports.

  • Capital account

    This is where is where all international capital transfers are recorded. It also includes net sales of non-produced, non-financial assets. Capital inflow transactions are recorded as credits and capital outflow transactions are recorded as debits.

  • Financial account

    This documents all international monetary flows related to investment in financial assets such as bonds and stocks. Also included are government-owned assets such as foreign reserves, gold, and special drawing rights (SDRs) held with the International Monetary Fund.

Analysts often lump financial account and capital account into one category named "capital account," which consists of portfolio investment flows (short-term) and foreign direct investment (long-term).

Example

A U.S. citizen purchases a rug from India for $100. The U.S. debits its current account for $100. Now the Indian rug-maker has two options:

  • Deposit the $100 into a U.S. bank. The U.S. asset (a bank deposit) will show up as a credit to the U.S. capital account.
  • Convert the $100 to rupees. The Indian bank then has 2 options.

    • Lend the $100 to a customer for the purchase of U.S. goods. This is to credit the U.S. current account.
    • Purchase U.S. government bonds. This is to credit the U.S. capital account.

In each case the balance of payments will balance.

The balance of payments must balance, meaning the balances of these three components must sum to zero. A deficit in one area implies an offsetting surplus in other areas. A current-account deficit implies a capital-account surplus (and vice versa).

What do these balances mean in economic terms? A country that runs a current account deficit is spending more than it produces, making up the difference between how much a country saves and how much it invests. A rising current account deficit could imply rising investment or falling saving, or both.

CA = Sp + Sg - I
To reduce a current account deficit, a country must save more and/or invest less. Higher saving can come from the private sector or from the government through a smaller budget deficit.

Net exports are exports of goods and services, X, minus imports of goods and services, M. Net exports are determined by the government budget and by private saving and investment.

  • The government sector surplus or deficit is equal to net taxes, T, minus government purchases of goods and services, G. This is Sg.
  • The private sector surplus or deficit is saving, Sp, minus investment, I.
  • Net exports is equal to the sum of the private sector balance and the government sector balance:

    NX = T - G + S - I = Sp + Sg - I

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