6.1 - Balance of Payments Accounts
The Open Economy
An open economy is one where international trade and financial investment happen. The Balance of Payments (BOP) summarizes transactions between people in different countries (not between the countries themselves) and has two parts: the Current Account and the Capital and Financial Account.
Current Account (CA)
Covers transactions that are paid for and settled right away:
- Net exports (the balance of trade): exports minus imports of goods and services. Selling domestic goods and services abroad (exports) brings money in, and buying foreign ones (imports) sends money out. Services count too: a French tourist paying for a hotel in New York is a U.S. export.
- Net unilateral transfers: one-way payments with nothing bought in return, like sending money home to family in another country or giving foreign aid. It’s transfers received from abroad minus transfers sent abroad.
- Net income from abroad (factor income): rent, wages, interest, and profits earned in another country. It’s the income residents earn from abroad minus the income foreigners earn here. Dividends an American gets from a German company count as money in; interest the U.S. pays to foreigners who own U.S. bonds counts as money out.
If more money flows out than in, the CA is in deficit; more in than out, it’s in surplus. The trade balance is exports minus imports; a trade deficit just means a country bought more foreign goods than foreigners bought from it, meaning its people are enjoying more stuff overall.
The trade balance is part of the CA, not the whole thing. Both can show a surplus or a deficit, and they usually move together, but they aren’t the same number: a country with a small trade deficit could still have a CA surplus if it earns enough income from its investments abroad.
Capital and Financial Account (CFA)
Covers the buying and selling of assets between countries, things like stocks, bonds, currency, bank deposits, real estate, and company ownership. More inflows than outflows means a CFA surplus (a net financial capital inflow); more outflows than inflows means a deficit (a net financial capital outflow). When foreigners buy U.S. stocks or bonds, money flows in, and that boosts the U.S. CFA balance. When Americans buy foreign assets, like a U.S. company building a factory in Mexico, money flows out, and that lowers it.
Credits and Debits
The BOP covers a set time period (usually a quarter or a year), and every international transaction gets entered as a credit or a debit:
- Credit: any transaction that makes money flow into the country. Exports, income earned abroad, transfers received, and foreigners buying domestic assets (a Japanese bank buying a U.S. Treasury bond) are all credits.
- Debit: any transaction that makes money flow out. Imports, income paid to foreigners, transfers sent abroad, and residents buying foreign assets (that factory in Mexico) are all debits.
Each transaction actually shows up twice, once as a credit and once as a debit, so the sum of all credits matches the sum of all debits. Say an American buys a $40,000 German car. That’s a $40,000 debit in the U.S. current account (an import). If the German carmaker holds on to those dollars (keeps them in a U.S. bank or uses them to buy U.S. bonds), foreigners now own $40,000 more in U.S. assets, a $40,000 credit in the U.S. CFA. If it spends them on U.S. goods instead, that’s a $40,000 export, a credit in the CA. Either way, credits match debits.
The Balance of Payments Identity
The whole BOP has to balance:
So . If a country runs a current account deficit, it must be running a capital and financial account surplus. In other words, money that leaves the U.S. to buy foreign goods comes right back in as foreigners investing in American assets, money isn’t just lost when it crosses a border.
How Changes Show Up in the BOP
Since CA + CFA = 0, anything that pushes one account up pushes the other down by the same amount. A few examples for the U.S.:
- Exports rise: a credit in the CA, so the CA balance rises (toward a surplus, or a smaller deficit). The payment for those exports ends up as a matching debit in the CFA, so the CFA balance falls by the same amount. For example, a U.S. seller paid in euros keeps them in a European bank, which counts as an American buying a foreign asset.
- More money sent abroad (bigger remittances or more foreign aid): a debit in the CA, so the CA balance falls. The people receiving those dollars now hold U.S. assets, so the CFA balance rises to match.
- Foreigners buy more U.S. stocks and bonds: a credit in the CFA, so the CFA balance rises (a bigger financial capital inflow). For the BOP to still balance, the CA balance falls, and the exchange rate is the link: buying U.S. assets takes dollars, so demand for dollars rises and the dollar appreciates, which cuts U.S. exports and raises imports (6.5).
Calculating the CA, CFA, and BOP
AP questions give you a list of transactions and ask for the trade balance, the CA, or the CFA. Example for Country X:
Transaction | Amount (billions of dollars) |
Exports of goods and services | 400 |
Imports of goods and services | 550 |
Income received from abroad | 70 |
Income paid to foreigners | 40 |
Transfers received from abroad | 10 |
Transfers sent abroad | 30 |
Foreign purchases of Country X assets | 290 |
Country X purchases of foreign assets | 150 |
- Balance of trade = exports minus imports = , a trade deficit of 150.
- Current account = net exports + net income from abroad + net transfers = , a CA deficit of 140. Notice it isn’t the same as the trade balance.
- Capital and financial account = foreign purchases of Country X assets minus Country X purchases of foreign assets = , a CFA surplus of 140 (a net financial capital inflow).
- Check the BOP: CA + CFA = . If a question only gives you one account, flip the sign to get the other: a CA deficit of 140 means a CFA surplus of 140.
Bottom line: the BOP tracks the current account (goods, services, income) and the capital and financial account (financial assets), and the two always sum to zero. A trade deficit means a country is simultaneously receiving foreign investment.