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January 18, 2011

Balancing Viewpoints on the Balance of Payments

By Cindy Ivanac-Lillig

The Balance of Payments (BOP) is the sum of all the international transactions a country makes. The BOP basically consists of:

• The current account -- the sum of the trade account (exports minus imports), net factor income (payments to residents minus payments to foreigners from investments and remittances) and net transfer payments (foreign aid).


• The capital account (sometimes referred to as the financial account) -- the sum of international investments, loans, and government transactions.

In the field of economics, we hear more about the current account than the capital account. I think this is because it is partially included in the GDP formula, which all economists know and love. The trade account (NX), is a subset of the current account and it is included in our GDP formula (Y=G+I+C+NX).

So, I bet everyone reading probably knows that the U.S. runs a trade deficit (large part of current account), but how many of us stop and think that this means we must be running a capital account surplus. After all, the BOP is an identity, so one account must offset the other. What does running a capital surplus mean? This means lots of people buy American assets, and we can thus use this capital to invest or consume. Realizing this helps to explain why it’s just too simplistic to theorize that if we were to export more goods and services, more jobs would be created. If our net exports were to improve, it would follow that our capital account surplus would diminish and that would somewhat offset our ability to consume and invest. The distribution of employment would probably shift, but the idea that there would be more jobs overall is not entirely clear.

The current and financial accounts are interesting in and of themselves, but the dynamic between the two is much more interesting.

There is a lot of talk in the press and blogosphere about China's currency revaluation and how that relates to the U.S. economy and our trade deficit (part of the current account). Instead of looking at the trade account, it may be interesting for your classes to look at China's capital account and how the liberalization of that will affect the U.S. economy. It is really unique opportunity to look at one of the fastest-growing economies (China) versus one of the most developed (U.S.) through this new lens.

Let me know what you think?

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Posted by Cindy at 4:47 PM | Comments (9) | TrackBack