The Balance of Payments

You’ll be able to

Identify the components of the current account and the financial (capital) account
Classify international transactions into the correct account
Explain why the current and financial accounts offset each other

A record of transactions with the world

The balance of payments is a record of all economic transactions between a country and the rest of the world over a period. It has two main accounts. The current account tracks trade in goods and services (exports minus imports), plus investment income and net transfers (like remittances and foreign aid). The financial account (also called the capital account on the AP exam) tracks flows of financial assets — foreign purchases of domestic assets and domestic purchases of foreign assets, including foreign direct investment and portfolio investment.

The two accounts offset

The balance of payments as a whole must balance: the current account and the financial account are mirror images that sum (roughly) to zero. Intuitively, when a country runs a current account deficit (it imports more goods and services than it exports), it pays for the difference by selling assets to foreigners — a financial account surplus (capital inflow). A country with a current account surplus lends to or invests in the rest of the world, running a financial account deficit. Money spent on imports comes back as foreign investment.

Classifying transactions

To place a transaction, ask whether it involves a good, service, income, or transfer (current account) or the purchase/sale of a financial asset (financial account). A U.S. resident buying a German car → import of a good → current account. A Japanese firm buying a U.S. factory or U.S. Treasury bonds → capital inflow → financial account. Interest a country earns on assets held abroad → investment income → current account. Keeping the "goods/services/income vs. assets" distinction clear is the key skill here.

Balance of payments identity

Current account + Financial (capital) account ≈ 0

A current account deficit is matched by a financial account surplus (net capital inflow), and vice versa. The two accounts offset.

Worked example

Classify each transaction and state its effect on the U.S. current or financial account: (1) A U.S. consumer buys $500 of imported electronics. (2) A British investor buys $500 of U.S. corporate stock.

1.Transaction 1 is the import of a good, so it belongs to the current account and worsens (subtracts from) the current account balance.
2.Transaction 2 is a foreign purchase of a U.S. financial asset (stock), so it belongs to the financial account as a capital inflow, adding to the financial account balance.
3.Notice the offset: the $500 that left as payment for imports returns as $500 of foreign investment in U.S. assets.
4.Net effect: current account −$500, financial account +$500, summing to zero.

Answer: The electronics import is a current account debit (−$500); the British stock purchase is a financial account credit (+$500). Together they illustrate the offset: a current account deficit is financed by a financial account surplus.

Checkpoint

A German pension fund purchases $10 million of U.S. Treasury bonds. In the U.S. balance of payments, this transaction is recorded in the:

Watch out

The purchase of a financial asset (stocks, bonds, real estate) goes in the financial account, while the income it earns later (interest, dividends) goes in the current account. Do not put the asset purchase in the current account just because money changed hands.

Checkpoint

A country runs a large current account deficit. What must be true of its financial (capital) account, all else equal?

On the exam

Remember the offset: current account deficit ⇔ financial account surplus. If an exam prompt says a nation imports far more than it exports, expect a matching inflow of foreign capital financing that gap.

Answer the 2 checkpoints as you read.