Looking at the flow of money in and out of countries around the world.

Balance of payments

Looking at the flow of money in and out of countries around

the world

Flow of money

Money is constantly flowing around the world as people, businesses and government transact

business with other countries. People travel, goods are imported and exported, investments

are made….

The balance of payments records the

transactions between residents of a country and the residents of all other countries.

Credits show money coming in to the country while debits show money leaving the country.

By definition, the sum of credits and debits always equals zero

Balance of payments

Obviously different countries have different currencies. If a Canadian travels to India, she must exchange her Canadian dollars for Indian rupees in the foreign exchange market. She

demands Indian rupees and supplies Canadian dollars within the foreign exchange market.

The foreign exchange market facilitates financial transactions among people,

businesses and governments as they interact with other countries.

Foreign Exchange

When trading one currency for another, the

demand for a particular foreign currency generates a supply of the domestic currency (and vice versa). So all money coming into India (credits) must originate with a demand

for rupees, while all money leaving India (debits) must begin with a supply of rupees to

buy a foreign currency.

Supply and demand

A country’s balance of payments is presented

in chart or table form with three main categories. These categories are:

The current account

The capital account

The financial account

Balance of payments

The current account lists exports of a country

(credit) as well as imports to the country (debit) for both goods and services. If a country’s exports of goods and services

exceed their imports, then they will have a surplus on its balance on goods and services. Additionally, net income and net transfers are listed in the current account. A country like

the USA has a negative current account balance (deficit) because its imports greatly

exceed its exports.

Current Account

For a country like the USA with a deficit in its

current account, more dollars are supplied in the foreign exchange market than dollars are

demanded. So the sum of debits is larger than the sum of credits.

The trade balance is the largest of all the categories within the current account, so a

country like China would have a surplus in its current account because it is a net exporter.

Current Account

The capital account shows the net flow of funds for the purchase of assets such as land

or natural resources. This is not a large part of the balance of payment equation, and may be

either positive or negative.

Capital Account

The financial account shows the net flow of

funds into and out of the country in the form of assets, foreign investments and loans to or from other countries. A country like the USA has a positive balance in its financial account

as it receives more funds from foreign countries in the form of investments and purchases of USA physical capital, than

Americans invest abroad.

Financial Account

The USA has a surplus in its financial account

meaning that credits exceed debits and the quantity of dollars demanded exceeds the

quantity of dollars supplied. Therefore there is an excess of US dollars demanded in the

foreign exchange market.

Financial Account

The moral of the story is that for every country

the value of the current account will be offset by the value of the capital account plus the

value of the financial account, which is why its called the balance of payments.

The quantity of domestic currency demanded will be equal to the quantity of domestic

currency supplied for two reasons…..

Balance of Payments

Reason 1—A country’s central bank can buy

and sell foreign currency to create a balance of payments

Reason 2—Changes in exchange rates can also create a balance of payments

Balance of Payments

If for some reason there isn’t exact equality

between the current account and the combined capital account and financial

account, an entry called statistical discrepancy will be listed to ensure that a

balance of payments is arrived at.

This will create a situation where the credits and debits are equal to zero

Statistical Discrepancies

A country like the USA which is a net importer

therefore has a deficit in its current account. It is enjoying a level of consumption beyond

its PPC. The USA must have a surplus in its financial

account therefore to achieve its balance of payments, which may come from foreign

investments in the USA or loans made to the USA by foreign countries.

Another perspective

A country like China which has a surplus in its

current account balance because it is a net exporter is consuming beneath its PPC.

China, by selling so many exports, has a vast amount of foreign currency which it uses to

buy foreign assets or to make loans to foreign countries. Therefore China has a negative

financial account balance leading to its balance of payments.

Yet another perspective