7 Things to Know About the Balance of Payments
11/29/2021 Jacob Reed
Comprehending the balance of payments is important to fully understand the interdependence between economies around the world. The balance of payments is critical to macroeconomics because it has a connection to all of the macroeconomic models.
The balance of payments includes two accounts which track payments between countries. The first account is the current account. It tracks payments for goods and services as well as money transfers between countries. The second account is the financial account (sometimes called the capital account). This account primarily tracks payments for assets between countries.
1.What is included in the current account?
The current account includes payments for goods, payments for services, investment income, and transfers of money. When a US firm imports goods made in India, the payment counts as a credit (plus) in India’s current account and a debit (minus) for the US current account. If a US firm provides consulting services to a Jamaican firm, the payment for those services would be recorded as a credit in the US current account and a debit for Jamaica’s current account. If a Chinese business woman purchases a coal mine in the US, then earns profits from that coal mine, the profits (payments to the entrepreneur) would be counted as a credit to China’s current account and a debit to the US current account. If a British immigrant to the US works in the United States then sends money home to his family, that transfer of money would count as a debit for the US current account and a credit for Great Britain’s current account.
Price levels and real output found in the AS/AD model impact an economy’s current account. When price levels rise, foreign goods become relatively cheaper and domestic goods become relatively more expensive. As a result, an increase in a country’s price level reduces exports, and increase imports (decreases Xn). If a country’s output increases, that means national income has increased. More income means more purchasing of everything; including foreign goods. As a result, an increase in real output corresponds to an increase in imports.
2. What is the balance of trade?
Two components of the current account are payments for goods and services between countries. Together, these payments make up the trade balance (a sub account of the current account). Exports of goods and services are counted as a credit in the current account and imports of goods and services are counted as a debit in the current account. If exports are greater than imports the country has a trade surplus. If imports are greater than exports, the country has a trade deficit. (To see the current US trade balance see the St. Louis Fed)
Note: When a country has a trade deficit, it does not necessarily have a deficit in the current account.
3. What is included in the financial and capital account?
The Advanced Placement macroeconomics exams most often refer to this account as the financial account. It could also be referred to as the capital account, but whatever it’s called, make sure you know what is included in this account.
The financial (capital) account includes payments for assets. Those assets can be physical assets like factories, office buildings, and mines (for just a few examples), or they could be financial assets like bonds or certificates of deposit. It is important to note that physical capital which is exported counts in the current account, but if physical capital stays put (like an office building) while only changing ownership, it is counted in the financial account.
If an American entrepreneur purchases a banana farm in the Philippines, the payment for this asset would be counted in the financial account. It would be a credit for the Philippines and a debit for the United States. If an investor in Japan purchases US savings bonds, that payment would be counted as a credit in the US financial account and as a debit in Japan’s financial account.
The flows of financial capital in and out of an economy are impacted by the equilibrium interest rates in the money market and loanable funds market. When interest rates rise, money flows into the economy as foreign investors seek the high interest rate. When interest rates fall, money flows out of the economy as foreign investors abandon the relatively low interest rate and seek a higher one. Financial capital going into an economy is called an inflow; financial capital going out is called an outflow. Both of these change the financial capital stock (how much financial capital is presently in the country).
4.How do you know if a payment is a debit or credit?
The key here is to follow the money. Money in is a credit and money out is a debit. So when a citizen of country A makes a payment to a citizen of country B, country A has a debit and country B has a credit. There have been questions in the past that start with the assumption an account is balanced (has a value of zero). Then, the question asks if a payment will create a deficit or surplus. Deficits are negative numbers and surpluses are positive numbers. So a credit would create a surplus and a debit would create a deficit.
5.How do the current account and financial (capital) account balance?
The current account plus the financial account will always equal zero. That is because money that leaves the economy will come back. If the US increases imports (which decreases net exports), those imports will count as a debit in the US current account. The US dollars used (or exchanged for other currencies to be used) to pay for the imports, must come back to the US economy. They will be used to purchase American assets. That creates a credit in the US financial account equal to the debit in the current account; bringing the accounts back into balance.
If there is credit in the current account, there must be an equal debit in the current account or a debit in the financial account. If there is a credit in the financial account, there must be an equal debit in the financial account or a debit in the current account.
6.How does the balance of payments impact foreign exchange markets?
When money flows into an economy (it doesn’t matter which account), it increases the demand (and generally reduces the supply) of that country’s currency in the foreign exchange markets. When money flows out of an economy, it increases the supply (and generally reduces the demand) for the country’s currency in the foreign exchange markets.
7. How does the foreign exchange market impact the balance of payments?
When the US Dollar appreciates, US products get more expensive to foreign consumers and foreign products get cheaper to US consumers. As a result, an increase in the value of the US dollar causes imports to increase and exports to decrease which decreases the current account balance (and increases the trade deficit).
The reverse is also true. If the US dollar depreciates, the US will import less and export more which will increase the current account balance (and decreases the trade deficit).