Unit 6 · Topic 6.1

Balance of Payments Accounts

The balance of payments has two halves.

Practice 1: Principles and ModelsPractice 2: Interpretation

Part 1 · Hook

Why this matters

Every time someone in the United States buys a phone assembled abroad, streams a show made by a foreign studio, or sells a Treasury bond to an investor in another country, money crosses a border. Countries keep one record of all of it, and that record has a rule that never breaks: its two halves always add up to zero.

Part 2 · Before you start

What this builds on

Part 3 · Prerequisite check

Quick check before you start

1. In GDP = C + I + G + (X - M), what does X - M stand for?

  1. Net exports
  2. Total exports
  3. Government purchases from abroad
  4. Investment by foreign firms
Show the answer

X is exports and M is imports, so X - M is net exports: what a country sells abroad minus what it buys from abroad.

  • Correct: Net exports:
  • Total exports:
  • Government purchases from abroad:
  • Investment by foreign firms:

2. Which of these is a financial asset?

  1. A government bond
  2. A haircut
  3. A loaf of bread bought for dinner
  4. An hour of a worker's time
Show the answer

A bond is a claim to future payments, a financial asset. The others are goods, services or labor.

  • Correct: A government bond:
  • A haircut:
  • A loaf of bread bought for dinner:
  • An hour of a worker's time:

Part 4 · See it

See it first

Two panels for the invented country Arland, in billions of arls. Current account: exports of goods and services plus 400, imports minus 520, net income from abroad plus 30, net transfers minus 10, for a current account balance of minus 100, a deficit. Capital and financial account: foreigners buy Arland assets plus 250, Arlanders buy foreign assets minus 150, for a balance of plus 100, a surplus. The two balances sum to zero.
A current account deficit of 100 is matched by a capital and financial account surplus of 100: the two halves of the balance of payments sum to zero. LevlPrep original diagram.

Part 5 · Step by step

How it works, step by step

  1. A country pays the rest of the world more for goods, services, income and transfers than it receives from itits current account balance is negative, a current account deficit
  2. Those extra purchases still have to be paid forthe country sells assets (bonds, stocks, land, firms) to foreigners or borrows from them
  3. Foreigners buy more of its assets than it buys of theirsits capital and financial account is in surplus by exactly the size of the current account deficit
  4. Every payment has a matching entrycurrent account + capital and financial account = 0

Part 6 · Key ideas

Key ideas

  • The balance of payments records every transaction between a country's residents and the rest of the world over a period. Money coming in is a credit (+); money going out is a debit (-).
  • The current account holds the balance of trade in goods and services (net exports), net income from abroad (interest, dividends, wages) and net transfers (gifts, aid, money sent home).
  • The capital and financial account records purchases and sales of assets: bonds, stocks, bank deposits, real estate and whole firms. A foreigner buying a domestic asset is a credit; a resident buying a foreign asset is a debit.
  • Current account + capital and financial account = 0. A current account deficit is matched by a capital and financial account surplus of the same size.
  • A government budget deficit (outlays above revenue) is not a trade deficit or a current account deficit.

Part 7 · Misconception

A common mistake

The wrong idea: The capital and financial account has nothing to do with trade, so a current account deficit tells you nothing about it.

What actually happens: They are two sides of the same payments. A country that buys more from abroad than it sells pays the difference by selling assets or borrowing abroad, so a current account deficit of 60 means a capital and financial account surplus of 60.

Part 8 · Check yourself

Check yourself

Exam-style questions. Anything you miss goes into your review queue.

Data

Arland's international transactions in one year

Arland's transactions with the rest of the world, billions of arls (invented data for practice)
TransactionAmount
Exports of goods300
Imports of goods380
Exports of services120
Imports of services90
Income received from abroad (interest, dividends, wages)45
Income paid to foreigners30
Net transfers sent abroad (gifts, aid, money sent home)25
Arland residents' purchases of foreign assets90

1. Use the table. What is Arland's balance of trade in goods and services, in billions of arls? Write a deficit as a negative number.

Type a number. A four-function calculator is allowed, as on the exam.

Show the answer

Exports minus imports, goods and services together: (300+120)−(380+90)(300 + 120) - (380 + 90)=420−470= 420 - 470=−50= -50. Arland bought 50 billion arls more from abroad than it sold, a trade deficit.

  • Answer: -50

2. Use the table. What is Arland's current account balance, in billions of arls? Write a deficit as a negative number.

Type a number. A four-function calculator is allowed, as on the exam.

Show the answer

The current account adds the balance of trade, net income and net transfers: −50+(45−30)−25-50 + (45 - 30) - 25=−60= -60. Purchases of foreign assets are not in it; they belong to the capital and financial account.

  • Answer: -60

3. Use the table. What is Arland's capital and financial account balance, in billions of arls? Write a deficit as a negative number.

Type a number. A four-function calculator is allowed, as on the exam.

Show the answer

The two accounts sum to zero: current account + capital and financial account = 0, so the capital and financial account is −(−60)=+60-(-60) = +60, a surplus. Arland paid for its extra purchases by selling 60 billion arls more of assets to foreigners than it bought from them.

  • Answer: 60

4. What does a country's balance of payments record?

  1. The government's tax revenue minus its spending in a year
  2. The market value of the final goods and services produced in a year
  3. Every transaction between the country's residents and the rest of the world
  4. The total amount the country owes to foreign lenders
Show the answer

The balance of payments is the record of all transactions between a country's residents and the rest of the world during a period.

  • The government's tax revenue minus its spending in a year: That is the budget balance, a measure of government finances, not of transactions with other countries.
  • The market value of the final goods and services produced in a year: That is GDP. The balance of payments records transactions with the rest of the world.
  • Correct: Every transaction between the country's residents and the rest of the world: Right: trade in goods and services, income, transfers and purchases of assets, over a period such as a year.
  • The total amount the country owes to foreign lenders: That is a stock of debt built up over many years. The balance of payments records the flows during one period.

5. Belvia has a current account surplus of 35 billion bels this year. What is its capital and financial account balance?

  1. A surplus of 35 billion bels
  2. A deficit of 35 billion bels
  3. Zero, because asset trades are not counted
  4. It depends on the government budget balance
Show the answer

Current account + capital and financial account = 0, so +35 is matched by -35.

  • A surplus of 35 billion bels: The two balances sum to zero, so they have opposite signs: a current account surplus means a capital and financial account deficit.
  • Correct: A deficit of 35 billion bels: Right: 35 + (-35) = 0. Belvia earns more from the rest of the world than it spends there and uses the extra to buy foreign assets (or lend abroad).
  • Zero, because asset trades are not counted: The capital and financial account records asset purchases and is not zero here; the two accounts together sum to zero.
  • It depends on the government budget balance: The budget balance is not part of the balance of payments; the current account balance alone gives the answer.

6. A headline reads "Arland's government deficit hits a record." A classmate says this means Arland imported more than it exported. Which response is best?

  1. Correct: a government deficit and a trade deficit are the same number
  2. Correct, because a government deficit is recorded in the current account
  3. Not necessarily: a budget deficit is outlays above tax revenue, not imports above exports
  4. Not necessarily, because a deficit is recorded in the capital and financial account
Show the answer

A budget deficit (government outlays exceed revenue) is not a trade deficit (imports exceed exports).

  • Correct: a government deficit and a trade deficit are the same number: They are different measures: one compares government outlays with revenue, the other compares exports with imports.
  • Correct, because a government deficit is recorded in the current account: Government budgets are not entries in the current account; only the government's own transactions with foreigners, such as aid, appear there.
  • Correct: Not necessarily: a budget deficit is outlays above tax revenue, not imports above exports: Right: a budget deficit is about the government's finances. A trade or current account deficit is about transactions with the rest of the world. One does not tell you the other.
  • Not necessarily, because a deficit is recorded in the capital and financial account: The headline is about the government budget, which is not part of the balance of payments at all.

Part 9 · Summary

Summary

The balance of payments has two halves. The current account records trade in goods and services, income and transfers; the capital and financial account records purchases and sales of assets. Because every purchase from abroad is paid for somehow, the two balances sum to zero: a current account deficit comes with a capital and financial account surplus of the same size. And a budget deficit is a different thing altogether.

Part 10 · Up next

What comes next

Part 11 · Connections

Connections

Question set for this topic