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 = S_p + S_g - 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 S_g.
• The private sector surplus or deficit is saving, S_p, 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 = S_p + S_g - I

Practice Question 1

If U.S. exports are $100, imports are $120, net income from foreign investments is $10, and net transfers from abroad is -$20, then the U.S. has a current account ______.

A. deficit of $30
B. surplus of $240
C. deficit of $20

Correct Answer: A

The current account surplus is equal to U.S. exports - U.S. imports + net income from foreign investment + net transfers from abroad.

Practice Question 2

The three balance of payments accounts include all of the following except a ______.

A. financial account
B. current account
C. foreign exchange rate
D. capital account

Correct Answer: C

Practice Question 3

The difference between foreign investment in the United States and U.S. investment abroad is recorded in the ______.

A. current account
B. capital account
C. financial account

Correct Answer: C

Practice Question 4

The U.S. government's holdings of foreign currencies are recorded in the ______.

A. current account
B. capital account
C. financial account

Correct Answer: C

Practice Question 5

If U.S. exports are $200, imports are $300, net income from foreign investments is $20, and net transfers from abroad are -$50, then the U.S. has a capital/financial account ______.

A. deficit of $100
B. surplus of $130
C. surplus of $50

Correct Answer: B

The current account plus the capital/financial account equals zero. The current account: 200 - 300 + 20 - 50 = -130.

Practice Question 6

The part of the balance of payments account that lists net sales of non-produced assets is called the ______.

A. current account
B. capital account
C. financial account

Correct Answer: B

The capital account balance mainly consists of capital transfers and net sales of non-produced, non-financial assets.

Practice Question 7

Net exports is equal to ______.

A. T + G - S - I
B. T - I - G + S
C. G + S - T - I

Correct Answer: B

Net exports are determined by the government budget (T - G) and by private saving and investment (S - I).

Practice Question 8

Payments for imports of goods and services from abroad, receipts from exports of goods and services sold abroad, net interest income paid abroad, and net transfers are recorded in the ______.

A. current account
B. capital account
C. financial account

Correct Answer: A

The current account balance largely reflects trade in goods and services.

Practice Question 9

A firm in Peru purchases stock (less than 5%) in a U.S. company. The transaction should be recorded in the U.S. balance of payments as a ______ on the ______ account.

A. credit; financial
B. credit; capital
C. debit; capital

Correct Answer: A

Capital inflow: credit. Financial assets: financial account.

Practice Question 10

Stock dividends from foreign investment should be recorded as a ______ on the ______ account while interest payments from foreign government bonds should be recorded as a ______ on the ______ account.

Correct Answer: They should both be recorded as credit on the current account.

Practice Question 11

An economy with a current account deficit is effectively importing ______.

A. present consumption and exporting past consumption
B. past consumption and exporting present consumption
C. present consumption and exporting future consumption

Correct Answer: C

International capital flows essentially reflect an inter-temporal trade.

Practice Question 12

An economy's private savings can be used for ______.

I. domestic investment
II. net exports
III. redemptions of government debt

Correct Answer: I, II and III

S = I + CA - Sg

Practice Question 13

A current account deficit tends to result from a combination of ______.

I. low private savings
II. high private savings
III. low private investment
IV. high private investment
V. government deficit
VI. government surplus

Correct Answer: I, IV and V

CA = Sp + Sg - I

Practice Question 14

The sale of intangible assets should be captured in which of the following balance of payments components?

A. Current account
B. Capital account
C. Financial account

Correct Answer: B

Practice Question 15

When a German consumer purchases a Canadian chainsaw, this transaction is recorded as a ______.

A. debit on the German current account
B. credit on the German current account
C. debit on the Canadian current account

Correct Answer: A

Every international transaction enters the balance of payments twice (once as a credit and once as a debit). One side of the transaction is a debit to the German current account, because it has to do with the import of merchandise. Additionally, the other side of the transaction will eventually result in a credit to the German balance of payments (either the capital or current account), depending on the action of the Canadian company.

Practice Question 16

The record of all transactions with foreign nations that involve the exchange of merchandise goods and services, net income earned abroad, and unilateral gifts is called the ______.

A. capital account
B. current account
C. balance of trade

Correct Answer: B

The current account is more encompassing than either the balance of merchandise trade or the balance of goods and services.

Practice Question 17

If a nation is running a surplus in its current account, ______

A. it is running a deficit in its capital/financial account.
B. it is running a surplus in its capital/financial account.
C. its net unilateral transfers or net income earned abroad must be negative.

Correct Answer: A

A surplus in the capital/financial account must be balanced by a deficit in the capital account. That is how the balance of payments "always balances." Negative unilateral transfers or net income earned abroad would contribute to a current account deficit.

Practice Question 18

Which of the following items is a credit in the U.S. balance of trade?

A. The sale of a life insurance policy to an Italian by an American company
B. The purchase of a German car by an American
C. A short-term loan extended to a South American by a U.S. resident

Correct Answer: A

The balance of payments is a summary of all economic transactions between a country and all other countries for a specific period of time. Transactions that create a demand for the nation's currency (or a supply of foreign currency) on the foreign exchange market are recorded as a credit or plus item. The only example of such an occurrence is when an Italian demands U.S. currency in order to purchase a life insurance policy from a U.S. company. He must pay for the policy in dollars and therefore supplies Euros to the market in exchange for U.S. dollars.

Practice Question 19

Propelled by an older population and a high saving rate, Japanese citizens make substantial real and financial investments abroad. If Japanese investment abroad exceeds foreign investment in Japan (a financial account deficit), and we assume the capital account balance is zero, the Japanese ______

A. must run an offsetting surplus on their current account transactions.
B. yen must appreciate on the exchange rate market.
C. yen must depreciate on the exchange rate market.

Correct Answer: A

According to the balance of payments, which requires that the capital/financial account exactly offsets the current account, the Japanese must have a current account surplus.

Practice Question 20

Which of the following is true?

A. All central bank transactions are excluded from balance of payment accounts.
B. All cash flows associated with foreign investments belong to the capital account.
C. Repatriation of domestic currency to a foreign country by foreign nationals living in the country is treated as part of the current account.

Correct Answer: C

A is false. Official assets are included in the financial account. B is false. Such cash flows belong to the financial account. However, income associated with investment is treated as part of the current account. C is a direct outflow of domestic currency and is treated as a debit entry on the current account.

Practice Question 21

In a given year, Gondolpha had total imports of 976 and total exports of 734. It also made direct foreign investments of 297. There were no other transactions on the BOP account. What's the current account deficit?

A. 242
B. 55
C. 539

Correct Answer: A

976 - 734 = 242

It's a deficit.

Practice Question 22

The coupon payments to a domestic investor from a foreign bond are represented as a ______ entry in the ______ account.

A. credit; current
B. debit; current
C. debit; financial

Correct Answer: A

Income on foreign investments is part of the current account.

To determine whether it is a debit or a credit entry, remember that, by convention:
1. Any inflow of domestic currency represents a credit and any outflow of domestic currency represents a debit on the BOP account.
2. Any inflow of foreign currency represents a debit and any outflow of foreign currency represents a credit on the BOP account.

Since the coupon income represents an inflow of domestic currency (from the foreign exchange markets, where the coupon payments in foreign currency were converted to domestic currency), it is a credit entry.

Practice Question 23

For an upcoming sightseeing visit to India, a U.S. resident recently purchased a hundred thousand Indian rupees. His action created a ______.

A. credit balance in the U.S. BOP account
B. debit balance in the U.S. BOP account
C. deficit in the U.S. trade account

Correct Answer: B

This is a point of convention where much confusion exists. Before you answer this question, you should remember two things:
1. In international finance, a country's reserve of foreign currency and foreign-produced goods is treated as an asset.
2. In accounting, by convention, increases in assets are recorded as "debit" entries and reductions are treated as "credit" entries.

In the above example, there is an inflow of Indian rupees and the transaction is hence recorded as a debit to the U.S. BOP account.

Practice Question 24

Which of the following would be recorded as a credit in the U.S. balance of payments accounts?

A. The purchase of a German business by a U.S. investor
B. European travel expenditures of an American college student
C. The purchase of a U.S. Treasury bond by a French investment company

Correct Answer: C

Since the purchase of a bond by a French company decreases the supply of U.S. dollars on the foreign exchange market, this transaction is accounted for as a credit on the U.S. balance of payments account.

Practice Question 25

In a purely floating exchange-rate economy, a shift toward a more expansionary monetary policy will move the capital/financial account toward a ______. The current account will move toward a ______.

A. surplus; deficit
B. deficit; deficit
C. deficit; surplus

Correct Answer: C

An expansionary monetary policy will speed up economic growth, increase inflation and decrease real interest rates by increasing the money supply. This decrease in real rates will cause an outflow of funds into economies offering higher rates, causing the domestic currency to depreciate. The outflow of funds will move the capital/financial account toward a deficit (or a smaller surplus). The current account will move toward a surplus since the changes in current and capital/financial accounts in a purely floating economy must equal zero. Over a slightly longer run, the depreciation in the domestic currency will increase exports and decrease imports, moving the current account further toward a surplus. Therefore, always look at the effects on the capital/financial account first.

Practice Question 26

Which of the following transactions belong to the current account?

I. Unrequited transfers
II. Purchase of a foreign company
III. Income from foreign investments

A. I, II and III
B. I and III
C. II and III

Correct Answer: B

The current account consists of trade and services balance, net income from all foreign investments, and unrequited transfers.

Practice Question 27

Which one is the most likely reason for a current account deficit?

A. Low private savings
B. Low private investment
C. Government surplus

Correct Answer: A

CA = Sp + Sg - I

Practice Question 28

Which one is the most likely reason for a current account surplus?

A. Low private savings
B. Low private investment
C. Government deficit

Correct Answer: B

CA = Sp + Sg - I

Practice Question 29

A current account surplus reflects high ______.

A. domestic private savings and investment, and government surplus
B. domestic private savings, low domestic investment, and government surplus
C. domestic private savings and investment, and government deficit

Correct Answer: B

CA = Sp + Sg - I