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 , the capital and financial account must decrease by . The fact that an entry in the current account is offset by an entry in the capital and financial account creates the mathematical identity:
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 . Panem paid for the trade deficit, but it needs to account for this new obligation in its balance of payments. The coming into the country is counted in the capital and financial account, and once again :
On the other hand, if Panem runs a trade surplus of , 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 , which will send funds out of the country:
Key equation: The balance of payments
The current account and the capital and financial account must sum to zero.
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.
FAQs
The main summary statements of the balance of payments accounts are the current account, the capital account, the financial account, and the net errors and omissions.
What is the balance of payments lesson note? ›
Lesson Summary
In summary, the balance of payments is a country's record of all transactions between its residents and the residents of all other foreign nations. The current account, financial and capital account make up the balance of payments.
What is the learning objective of balance of payment? ›
Objectives of Balance of Payments
It aims to track a country's surplus or deficit in its foreign transactions, revealing if it is a net lender or borrower to the rest of the world. It seeks to identify imbalances in different components of the balance of payments like the current account and capital account.
What is a country's balance of payment the summary of? ›
The BOP is a summary of the money entering and exiting a country over a period of time. It provides critical data that can be used to set economic policies and priorities, and the effect of those policies will in turn influence the BOP over time. Bureau of Economic Analysis. “International Trade & Investment.”
What is the simple explanation of balance of payments? ›
The Bottom Line. The balance of payments (BOP) is the method by which countries measure all of the international monetary transactions within a certain period. The BOP consists of three main accounts: the current account, the capital account, and the financial account.
What are the 3 main components of balance of payments? ›
There are three components of the balance of payment viz current account, capital account, and financial account. The total of the current account must balance with the total of capital and financial accounts in ideal situations.
What is the conclusion of the balance of payments? ›
Conclusion The balance of payments is very important for a country to try and keep equal. To low and you have a deficit to where you borrow money and to high and you're in a surplus which if taken lightly can actually lead to a deficit.
What does balance of payment always explain? ›
The balance of payments takes into account payments for a country's exports and imports of goods, services, financial capital, and financial transfers. It is prepared in a single currency, typically the domestic currency for the country concerned.
Why is the balance of payment important? ›
Businesses use BOP to analyze the market potential of a country, especially in the short term. A country with a large trade deficit is not as likely to import as much as a country with a trade surplus. If there is a large trade deficit, the government may adopt a policy of trade restrictions, such as quotas or tariffs.
What are the causes of deficits in balance of payments? ›
Causes of BoP Deficit
High outflow of foreign exchange to meet import demands like technology, machines, and equipment can lead to BoP deficit. Sustained rise in a country's prices can often make foreign products cheaper, leading to a high volume of imports. Unstable tax structures, change in government, etc.
What is a defining characteristic of a balance - of - payments statement? It is a record of the domestic transactions between the government of a country and the private companies in It records the trade policies of the member nations of the WTO.
What are the macro objectives of the balance of payments? ›
important macroeconomic policy objective
A balance of payments equilibrium on the current account means the country can sustainably finance the current account, which is important for long term growth. If it becomes difficult to attract sufficient capital flows, the pound could depreciate.
What are the principles of balance of payment? ›
Double-entry bookkeeping Principle: The balance of payments account of a country is constructed on the principle of double-entry bookkeeping. Each transaction is entered on the credit and debit side of the balance sheet. Thus, the total debit and the total credit of the balance of payments are always equal.
What are the characteristics of balance of payments? ›
Main characteristics of ' Balance of Payments ' are :1 Systematic Record - It is a record of payments and receipts of a country related to its import and export with other country. 2 Fixed Period of Time – It is an account of a fixed period of time generally a year.
What is the significance of a country's balance of payments? ›
The balance of payments summarises the economic transactions of an economy with the rest of the world. These transactions include exports and imports of goods, services and financial assets, along with transfer payments (like foreign aid).
What is the balance statement summary? ›
A balance sheet, an important financial tool, calculates a company's assets with its liabilities and equity. Total assets are calculated as the sum of all short-term, long-term, and other assets. Total liabilities are calculated as the sum of all short-term, long-term, and other liabilities.
What summarizes all the account balances for the financial statements? ›
A trial balance summarises the closing balance of the different general ledgers of the company, while a balance sheet summarises the total liabilities, assets, and shareholder's equity in the company.
What is the balance summary of an account? ›
Summary. An account balance is a statement that shows the total money available at the start of the accounting period. Credit cards and checking accounts are typical examples of accounts with account balances, and the pattern of their activities determines the credit score.
