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.
b. A higher real interest rate domestically will attract foreign savings. The financial account will move to a surplus as foreign financial assets are sent to this country. The current account balance will move into a deficit. As foreign funds come in, there are more funds available to buy imported goods, which will cause the current account to move into a deficit. The current account and financial account will always add up to zero, so if increases, the must decrease.
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 answer? ›
The balance of payment is the statement that files all the transactions between the entities, government anatomies, or individuals of one country to another for a given period of time. All the transaction details are mentioned in the statement, giving the authority a clear vision of the flow of funds.
What is the balance of payment lesson note? ›
Lesson Summary
The balance of payment (BOP) is a statement of all transactions between one country and all the other countries in the world. From a country's point of view, the money inflow and outflow transactions are recorded and useful for understanding the state of the country's economy.
How to calculate financial account balance in economics? ›
Balance of financial account = Net direct investment + Net portfolio investment + Assets funding + Errors and omissions.
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.
What is summarized on the balance sheet? ›
A balance sheet provides a summary of a business at a given point in time. It's a snapshot of a company's financial position, as broken down into assets, liabilities, and equity.
Why is the balance of payments important? ›
The balance of payments helps any country determine if its currency's value is appreciating or depreciating. It provides almost accurate information on the commercial and/or financial performance of the external sector of an economy.
What is the importance of the balance of payment? ›
Importance of Balance of Payment
It analyses all of a country's products and service exports and imports during a specific time period. It assists the government in determining the potential for a certain industry's export growth and developing policies to encourage such growth.
How to solve balance of payments problems? ›
This problem can be managed when exports start rising and imports start reducing. Policies must be created which will help in stimulating exports. Conditions should be created where people are more interested in purchasing domestic goods rather than importing goods.
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.
Balancing a lesson plan makes a class run more smoothly and provides more value to students. To balance your plan, you need to choose activities based not just on their content (vocabulary, grammar, etc.) but also on three other factors: Skills (listening, reading, speaking, writing) Interaction patterns.
What is the difference between balance of trade and balance of payment? ›
Balance of trade only keeps records of goods. On the other hand, BoP records keep records of goods and services. Balance of trade records a country's imports and exports of goods. On the other hand, the balance of payment records all the economic transactions.
Is the balance of payments always 0? ›
While the total balance of payments should be zero, this does not always occur in practice.
What is an example of a double entry balance of payment? ›
Double-entry Accounting System
For example, if a resident of an economy sells goods to a non-resident (i.e. exports) and receives foreign currency in return, the two related BoP entries are: goods exported (a credit) and an increase in financial claim on non-resident (a debit).
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 are the two main components of balance of payments? ›
The two main components of a balance of payment account are:
- Current account.
- Capital account.
Balance of Payments. A record of all economic transactions between the residents of the country and the residents of all other countries within a given period of time (1 year). Its role is to show all payments received from other countries (credits) and all payments made to other countries (debits).
What is a summary statement of all the transactions called? ›
Ledger is the principal book of accounts. Journal is kept only to facilitate for passing the entries. All entries which are passed in journal are posted in ledger. For every account , a separate ledger is opened. Ledger is a summary of all transactions relating to a particular account.
