Balance of Payments

Learning outcomes
• Define and understand the importance of the components of the
current and capital accounts of a country’s balance of payments.
• Use a simple algebraic model to relate the current account to savings,
investment, and the general government budget balance.
• Discuss the pros and cons of current account deficits.

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Balance of Payments
• A systematic statement of all the economic transactions between the
domestic economy and the rest of the world in a given period of time.
• The international transactions of a nation are divided into two
separate accounts
• Current account: record of the goods and services into and out of the country
• Capital account: record of the flow of financial capital to and from the
country

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Trade balance
• The trade balance- measures the difference between exports and
imports of goods and services
• Visible trade includes exports and imports of merchandise (goods)
• Invisible trade includes travel and transportation provided for the
movement of goods or of people. It also includes services such as
accommodation to tourists, insurance on goods, shipping services
and so on.
• Trade deficit: negative trade balance
• Trade surplus: positive merchandise trade balance

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Current account
• Current account balance: Measures all current, non-capital transactions between
a nation and the rest of the world
• The current account has three main components:
• Goods and services = the value of goods and services exported minus the
value of imports
• Investment income = income from investments abroad minus income paid to
foreigners on their investments in the home country
• Unilateral transfers = any foreign grants or other transfers received by home
country minus that given to foreigners. They may be official or private. They
do not give rise to corresponding receipts on part of the donors nor to
corresponding payments on part of receipients.

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Current account components
Credit Debit

1.Goods and services Exports Imports

2.Investment income Income received on foreign Income paid to foreigners on their

investment investments in the home country,
India

3.Unilateral transfers Transfers received from abroad Transfers made to foreigners

(remittances, grants)

There are three main components to the current account. Each component is divided into debit and credit
elements.

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Current account deficit (CAD)
• India experiences CAD
• Is a CAD a sign of weakness:
• A current account deficit is not a sign of weakness: an economic
boom increases the demand for imports, while sluggish growth
abroad limits the expansion of exports
• However, everyone agrees that the CAD should be sustainable in the
long term

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Capital account
• A record of the flow of financial capital to and from a country
• They include:
• Net changes in the country’s assets abroad
• Net changes in the foreign-based assets in the country
• Assets include bank accounts, stocks and bonds, and real property
such as factories, businesses, and real estate
A. Government assets: loans and rescheduled loans to foreign governments,
changes in non-reserve currency holdings (e.g., Mexican pesos)
B. Private assets: direct investment, foreign securities, loans to foreign firms
and banks

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• Subcomponents of private assets: foreign direct investment (FDI), foreign
securities, loans to foreign firms and banks
• FDI: tangible items: real estate, factories, warehouses, transportation facilities, and other
physical (real) assets
• Securities and loans can be considered foreign portfolio investment - paper assets such as
stocks and bonds
• Both FDI and foreign portfolio investment- claim in a foreign economy’s future output; FDI
have longer time horizons

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Two points about the capital account:
•First, the account presents the flow of assets during the year, not the
stock of assets that have accumulated over time
•Second, all flows are ‘net’ changes (differences between assets sold and bought,
for example) rather than ‘gross’ (stock) changes
•Net changes are informative because they measure the monetary
value of the change in a country’s financial stake in foreign economies

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Statistical discrepancy/errors and omissions
• Statistical discrepancy: The amount by which the sum of the current
and capital accounts is rounded off to zero ie the balance is zero

• Statistical discrepancy is calculated as the sum of the current and

capital accounts, with the sign reversed
• Statistical discrepancy exists because the record of all the transactions
in the balance of payments is incomplete

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• The current, capital, and financial accounts are interdependent
• Current account measures flow of goods and services
• Capital account measures the flow of financing
• Therefore, the amount on the capital account equals the amount on
the current account with opposite sign

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Official reserve assets
• Hard currencies of the largest and most stable economies (US dollars, EU euros,
British pounds, Japanese yen
• Gold
• Special Drawing Rights (SDR)
• U.S. securities, Treasury bills

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• Why study the balance of payments?
• Balance of payments help understand the broader implications of current
account imbalances and how to tame current account deficits
• Balance of payments give cues how nations can avoid crises brought by
volatile financial flows and how they can minimize the damage of financial
crises if such occur

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• National income and product accounts (NIPA): internal, domestic accounting
systems the countries use to keep track of total production and total income
• Two fundamental concepts of the system:
• Gross domestic product (GDP): the value of all final goods and services produced within a
country’s borders during a period of time (usually a year)
• Gross national product (GNP): the value of all final goods and services produced by the labor,
capital, and other resources of a country within the country as well as abroad

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• Interplay of the variables of the national accounts
1. GDP = C + I + G + X – M
2. GNP = GDP + (net foreign investment income + net transfers)
3. GNP = (C + I + G) + (X – M + net foreign investment income + net transfers)
4. GNP in terms of current account balance:
GNP = C + I + G + CA
5. GNP is also the value of income received: GNP = C + S + T
6. Since 4 and 5 are equivalent definitions of GNP,
C + I + G + CA = C +S + T
7. I + G + CA = S + T
8. S + (T – G) = I + CA

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• S + (T – G) = I + CA summarizes the current account balance,
investment, and public and private savings in the economy
• The relationship between the current account balance, investment,
and total national savings is an identity

• Consequently, it does not tell us why an economy runs a current

account deficit or surplus

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The current account balance has several meanings.
1. Net foreign investment (If).
CA = If
2. National saving (S) versus domestic investment (Id). S = Id + If, so that
CA = S – Id
3. Domestic production (Y) versus national expenditure (E).
Y = C + Id + G +(X – M),
E = C + Id + G, and CA = (X – M) approximately, so that
CA = Y – E
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Question
• Net unilateral transfers 250
• Exports of goods and services 500
• Net increase in the U.S. government’s nonreserve foreign assets 30
• Net increase in foreign ownership of U.S.-based nonreserve assets 400
• Net increase in U.S. private assets abroad 250
• Invest income received in the United States 200
• Net increase in U.S. ownership of official reserve assets 20
• Imports of goods and services 600
• Net increase in foreign ownership of U.S.-based reserve assets 100
• Investment income paid abroad by the United States 300

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• What is the current account balance?
• b. Does the capital account equal the current account?
• c. What is the statistical discrepancy?
• Answers:
• a. The current account is 500 + 200 − 600 − 300 + 250 = −250
• b. The capital account is 100 + 400 − 20 − 30 − 250 = 200
• c. The statistical discrepancy is –1 × (–250 + 200) = –250

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Look at each of the cases below from the point of view of the balance of payments
for the United States. Determine the subcategory of the current account or financial
account that each transaction would be classified in, and state whether it would
enter as a credit or debit.

• a. The U.S. government sells gold for dollars.

• b. A migrant worker in California sends $500 home to his village in Mexico.
• c. An American mutual fund manager uses the deposits of his fund
investors to buy Brazilian telecommunication stocks.
• d. A Japanese firm in Tennessee buys car parts from a subsidiary in
Malaysia.
• e. An American church donates five tons of rice to the Sudan to help with
famine relief.
• f. An American retired couple flies from Seattle to Tokyo on Japan Airlines.
• g. The Mexican government sells pesos to the United States Treasury and
buys dollars.
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a. The United States “exports” official reserve assets; it is a credit in the capital
account.
b. A resident of the United States unilaterally transfers money to a foreign locale; it
is a debit in the current account.
c. There is an “import” of foreign assets; it is a debit in the capital account under
the category of a net change in U.S. private assets abroad.
d. An American-based producer imports goods; it is a debit in the current account.
e. There is a unilateral transfer from the United States to abroad foreign country; it
is a debit in the current account.
f. American residents purchase a service from a foreign firm; it is a debit in the
current account.
g. There is a net increase in nonreserve foreign assets held by the U.S. government;
it is a debit in the capital account.

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