The balance of payments

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 a record of international transactions that do not create

account (CA) liabilities

a record of international transactions that do create

capital liabilities; the capital and financial account includes
financial official and private sales and purchases of financial
account (CFA) assets, such as bonds.

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
factor income U.S. current account.

money that is received from another country that is not

in exchange for a good, service, or financial asset; for
remittances example, when someone is working abroad and sends
Key term Definition
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$100dollar sign, 100, the capital and financial account must
decrease by \$100$100dollar sign, 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=−CFAC, A, equals, minus, C, F, A

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.

\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}Amount (in billions) +$200−$200$0+$0−$0
$0CA+FA
& Category Exports Imports Current account balance Financi
al assets received from other countries Financial assets sent to
other countries Capital and Financial account balance=$0+$0
=$0
What happens if Panem starts to run a trade deficit? Suppose Panem’s
imports increase to \$230$230dollar sign, 230:

\begin{aligned}\text{Amount (in billions) } \& & \text{

Category}\\\\ \blue{+\$200} & \text{ Exports}\\\\
\underline{\blue{-\$230}} & \text{ Imports}\\\\ \blue {-\$30}
& \text{ CA balance}
\end{aligned}Amount (in billions) &+$200−$230−$30
Category Exports Imports CA balance
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$30dollar sign, 30. Panem paid for the trade deficit, but it needs to
account for this new obligation in its balance of payments.
The \$30$30dollar sign, 30 coming into the country is counted in the
capital and financial account, and once again CA+CFA=0CA+CFA=0C,
A, plus, C, F, A, equals, 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}Amount (in billions) &+$200−$230
−$30+$30$0+$30CA+FA
Category Exports Imports CA balance Financial inflows Fina
ncial outflows CFA balance=−$30+$30=$0
On the other hand, if Panem runs a trade surplus of \$40$40dollar sign, 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$40dollar sign, 40, which will send funds out
of the country:

\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}Amount (in billions) +$240−$200+$40+$0−$40
−$40CA+FA
Category Exports Imports CA balance Financial inflows Fina
ncial outflows CFA balance=+$40+−$40=$0

Key equation: The balance of payments

The current account (CA)(CA)left parenthesis, C, A, right parenthesis and
the capital and financial account (CFA)(CFA)left parenthesis, C, F, A,
right parenthesis must sum to zero.

CA+CFA=0CA+CFA=0C, A, plus, C, F, A, equals, 0

Note that this equation can be rearranged to read

CA=-CFACA=−CFAC, A, equals, minus, C, F, A

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. CACAC, A 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.