In this lesson summary review and remind yourself of the key terms and calculations related to the balance of payments. Topics include the current account (CA) and the capital and financial account (CFA, sometimes called simply the capital account), and how the movement of goods, services, assets, and remittances appear in the BOP.
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 term | Definition |
---|---|
balance of payments | a 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 income | the 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. |
remittances | money 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
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.
What happens if Panem starts to run a trade deficit? Suppose Panem’s imports increase to
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
On the other hand, if Panem runs a trade surplus of
Key equation: The balance of payments
The current account
Note that this equation can be rearranged to read
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.
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
- 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.
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