Lesson Summary

The balance of payments tracks international transactions. When funds go into a country, a credit is added to the balance of payments (“BOP”). When funds leave a country, a deduction is made. For example, when a country exports 20 shiny red convertibles to another country, a credit is made in the balance of payments.

Key terms

Key termDefinition
balance of paymentsa record of all funds going in and out of a country
current account (CA)a record of international transactions that do not create liabilities
capital financial account (CFA)a record of international transactions that do create liabilities; the capital and financial account includes official and private sales and purchases of financial assets, such as bonds.
factor incomethe net of payments received and payments made on investments overseas; for example, if an American resident owns stock in a Japanese car company, any income earned on that stock is factor income in the U.S. current account.
remittancesmoney that is received from another country that is not in exchange for a good, service, or financial asset; for example, when someone is working abroad and sends money home to their family, that is a remittance.

Key takeaways

The current account (CA) and capital and financial account (CFA) records transfers and purchases between countries

The balance of payments is a system of recording transactions that happen between countries. Any movement of money into, or out of, a country has to be accounted for. We can use this flowchart to figure out where a transaction should go:
There are two categories in the BOP: the current account (CA) and the capital and financial account (CFA). If a transaction creates a liability, like selling a bond to another country, that gets counted in the capital and financial account. But if a transaction doesn’t create a liability (like the fancy red cars), the transaction gets counted in the current account.
Anything that occurs in one account is offset by the opposite happening in the other account. For example, if the current account increases by $100\$100, the capital and financial account must decrease by $100\$100. The fact that an entry in the current account is offset by an entry in the capital and financial account creates the mathematical identity:
CA=CFACA=-CFA

Trade deficits and surpluses in the balance of payments

A trade surplus exists if a country exports more than it imports. A trade deficit exists if a country exports less than it imports. To see how each of these situations impacts the balance of payments, let’s start with a simplified example of Panem’s balance sheet.
Amount (in billions) & Category+$200 Exports$200 Imports$0 Current account balance+$0 Financial assets received from other countries$0 Financial assets sent to other countries$0 Capital and Financial account balanceCA+FA=$0+$0=$0\begin{aligned}\text{Amount (in billions) } & \& \text{ Category}\\\\ \blue {+ \$200} & \text{ Exports}\\\\ \underline{\blue {- \$200}} & \text{ Imports}\\\\ \blue{\$0} & \text{ Current account balance}\\\\ \orange{+\$0} &\text{ Financial assets received from other countries}\\\\ \underline{-\orange{\$0}} & \text{ Financial assets sent to other countries}\\\\ \orange{\$0} & \text{ Capital and Financial account balance}\\\\ \blue{CA} + \orange{FA} &=\blue{\$0}+\orange{\$0}\\\\ &=\$0 \end{aligned}
What happens if Panem starts to run a trade deficit? Suppose Panem’s imports increase to $230\$230:
Amount (in billions) & Category+$200 Exports$230 Imports$30 CA balance\begin{aligned}\text{Amount (in billions) } \& & \text{ Category}\\\\ \blue{+\$200} & \text{ Exports}\\\\ \underline{\blue{-\$230}} & \text{ Imports}\\\\ \blue {-\$30} & \text{ CA balance} \end{aligned}
But how will Panem pay for this trade deficit? It will have to borrow money from other countries. Whenever an economy experiences a trade deficit, this will result in foreign financial assets entering the country. For example, Panem sells a bond to the nation of Hamsterville for $30\$30. Panem paid for the trade deficit, but it needs to account for this new obligation in its balance of payments. The $30\$30 coming into the country is counted in the capital and financial account, and once again CA+CFA=0CA+CFA=0:
Amount (in billions) & Category+$200 Exports$230 Imports$30 CA balance+$30 Financial inflows$0 Financial outflows+$30 CFA balanceCA+FA=$30+$30=$0\begin{aligned} \text{Amount (in billions) } \& & \text{ Category} \\\\ \blue{+\$200}& \text{ Exports}\\\\ \underline{\blue{-\$230}}& \text{ Imports}\\\\ \blue{-\$30} & \text{ CA balance} \\\\ \orange{+\$30} & \text{ Financial inflows} \\\\ \underline{\orange{\$0}} & \text{ Financial outflows}\\ \orange{+\$30} & \text{ CFA balance}\\\\ \blue{CA}+\orange{FA} &=\blue{-\$30} + \orange{\$30}\\\\ & = \$0 \end{aligned}
On the other hand, if Panem runs a trade surplus of $40\$40, it will be taking in more money from other countries than it sends out, creating a current account surplus. Panem will buy financial assets from other countries with that $40\$40, which will send funds out of the country:
Amount (in billions)  Category+$240 Exports$200 Imports+$40 CA balance+$0 Financial inflows$40 Financial outflows$40 CFA balanceCA+FA=+$40+$40=$0\begin{aligned} \text{Amount (in billions) }& \text{ Category} \\\\ \blue{+\$240}& \text{ Exports}\\\\ \underline{\blue{-\$200}}& \text{ Imports}\\\\ \blue{+\$40} & \text{ CA balance} \\\\ \orange{+\$0} & \text{ Financial inflows} \\\\ \underline{\orange{-\$40}} & \text{ Financial outflows}\\ \orange{-\$40} & \text{ CFA balance}\\\\ \blue{CA}+\orange{FA} &=\blue{+\$40} + \orange{-\$40}\\\\ & = \$0 \end{aligned}

Key equation: The balance of payments

The current account (CA)(CA) and the capital and financial account (CFA)(CFA) must sum to zero.
CA+CFA=0CA+CFA=0
Note that this equation can be rearranged to read
CA=CFACA=-CFA

Common misperceptions

  • Students new to the concept of balance of payments sometimes get confused about the “money” that is moving around in the capital and financial account. Changes in the capital and financial account impact the market for loanable funds, not the money market. When a country sends its financial assets to another country, it is really sending its savings. Recall that the supply of loanable funds is the sum of private savings, public savings, and net capital inflows. The capital and financial account tells you how much net capital inflow (or outflow) there is.
  • The capital that is being sent to and from countries in the capital and financial account is financial capital, not physical capital. Whenever you use the word capital, it’s good practice to specify the kind of capital you are talking about. If you are talking about the stock of physical equipment that can lead to economic growth, say “physical capital.” If you are talking about the flow of financial assets between countries, say “financial capital.”
  • Many people assume that a trade deficit is bad. CACA deficits aren’t necessarily bad because a country can consume more goods than they could produce domestically. However, deficits do create a future liability that will eventually need to be paid.

Questions for review

  1. The nation of Panem ran a budget deficit. As a result, it increased borrowing in the market for loanable funds.
a. Show the effect of an increase in government borrowing on interest rate using the market for loanable funds.
b. Assume that a country’s current account and financial account were both balanced before the increase in borrowing. What will happen to the current account (CA) and financial account (CFA) as a result of the change in the interest rate you indicated in part A? Explain.
a.
The real interest rate increases as a result of the increase in government borrowing.
b. A higher real interest rate domestically will attract foreign savings. The financial account will move to a surplus as foreign financial assets are sent to this country. The current account balance will move into a deficit. As foreign funds come in, there are more funds available to buy imported goods, which will cause the current account to move into a deficit. The current account and financial account will always add up to zero, so if FAFA increases, the CACA must decrease.
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