International Economics

Eighth Edition

Chapter 9
Trade and the Balance of
Payments

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Learning Objectives (1 of 2)
9.1 Define the current, capital, and financial accounts of a
country’s balance of payments.
9.2 Explain the importance of the three main components of the
current account.
9.3 Describe three types of international capital flows.

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Learning Objectives (2 of 2)
9.4 Use a simple algebraic model to relate the current account
to savings, investment and the general government budget
balance.
9.5 Discuss the pros and cons of current account deficits.
9.6 Show the relationship between a country’s balance of
payments and its international investment position.

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The Current Account (1 of 6)
• There are three accounts within the balance of payments.
1. The current account primarily tracks the flow of goods
and services between a country and the rest of the
world.
2. The capital account is the smallest of the three accounts
and records transfers of specialized capital assets
between countries.
3. The financial account is the record of all financial
transactions between a country and the rest of the
world.

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The Current Account (2 of 6)
• The current account balance has three separate components:
1. The trade balance is the largest component and is the
record of exports and imports of goods and services;
2. Income received from abroad minus income paid abroad,
called primary income;
3. Transfers made abroad minus transfers received from
abroad, called secondary income.

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The Current Account (3 of 6)
Blank Credit Debit
Goods and services Exports Imports
Primary income Investment income received Investment income paid to
from foreigners, and foreigners, and
compensation of employees compensation of foreign
at home received from employees abroad paid by
foreign firms. domestic firms.

Secondary income Transfers received from Transfers paid abroad.

abroad

• The three components of the current account.

• The difference between exports and imports is the trade balance.
• The difference between credits and debits is the current account balance.

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The Current Account (4 of 6)
• Primary income has two components:
1. Investment earnings received (credit) and paid (debit);
2. Wages and salaries received from abroad (credit) or paid
abroad (debit).
• Secondary income is often expressed on a net income basis:
transfers received minus transfers paid.
– A key item in this category is remittances, the part of
wages or other income that individuals transfer to families
and friends living outside the country.
– Countries with many immigrant workers send more
remittances abroad; countries with many emigrants
receive more remittances from abroad.

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The Current Account (5 of 6)
United States Current Account, 2019 Billions of dollars, 2014
1.Goods and services exports (credit) (lines 1a + 1b) 2,498
1a. Goods exports 1,653
1b. Services exports 845
2.Primary income receipts (credit) (lines 2a + 2b) 1,123
2a. Investment income received 1,116
2b. Compensation of employees received 7
3.Secondary income receipts (transfers) (credit) 143
4.Goods and services imports (debit) (lines 4a + 4b) 3,114
4a. Goods imports 2,519
4b. Services imports 595
5.Primary income payments (debit) (lines 5a + 5b) 866
5a. Investment income paid 846
5b. Compensation of employees paid 20
6.Secondary income payments (transfers) (debit) 282
7.Current account balance (lines 1 + 2 + 3 – 4 – 5 – 6) –498

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The Current Account (6 of 6)

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The Financial Account (1 of 9)
• The financial account is a record of financial flows between
countries.
• Financial flows represent the purchase of foreign assets by
home country residents and the sale of home country assets
to foreign residents.
• There are three main accounting categories and many types
of financial assets.
– Net acquisition of financial assets;
– Net incurrence of financial liabilities;
– Changes in financial derivatives.

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The Financial Account (2 of 9)
• Net acquisition of financial assets.
– Purchases of foreign financial assets;
– Includes items such as real estate, businesses, stocks, bonds,
bank loans, monetary gold, foreign currencies;
– A positive net acquisition means a country is buying more
foreign assets than it sells;
– A form of lending to foreigners.
• Net incurrence of liabilities.
– Foreign purchase of home country assets;
– The same items as above;
– A positive net incurrence of liabilities means that foreigners are
buying more home country assets than they are selling;
– A form of borrowing from abroad.

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The Financial Account (3 of 9)
U.S. Balance of Payments, 2019 Billions of dollars
1.Current Account Balance –498
2.Capital Account Balance 0
3.Financial Account
3a.Net U.S. acquisition of financial assets, excluding financial 427
derivatives (increase/outflow (+))
3b. Net U.S. incurrence of liabilities, excluding financial derivatives 784
(increase/inflow (+))
3c. Net change in financial derivatives –38
4.Statistical Discrepancy 102
5.Memoranda
5a.Balance on current and capital accounts (lines 1 + 2) –498
5b. Balance on financial account (lines 3a - 3b + 3c) –396

The financial account balance (5b) indicates net lending (positive) or net borrowing (negative).
The statistical discrepancy is the difference between net lending and borrowing on financial
account and the current plus capital accounts (line 5b minus line 5a).

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The Financial Account (4 of 9)
• A positive net acquisition of financial assets is a credit.
• A positive net incurrence of liabilities is a debit.
• The statistical discrepancy is the measurement error in the
accounts.
– In theory, the current account plus capital account equals
the financial account.
– In practice, there are measurement errors; the statistical
discrepancy equals the financial account balance minus
the current plus capital account balances.

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The Financial Account (5 of 9)
• If a country has a current account deficit, it must be financed.
– The deficit implies that the country consumes more than it
produces.
– The financial account shows the type of assets sold to
foreign residents by the deficit country.
• If a country has a current account surplus, it has savings it can
invest abroad.
– The surplus implies that the country produces more than it
consumes.
– The financial account shows the types of assets it acquires.

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The Financial Account (6 of 9)
• The main categories of assets in the financial account are:
– Foreign direct investment (FDI): Investment in real assets
(not paper assets) such as businesses, real estate,
factories.
– Portfolio investment: Investment in stocks and bonds and
other paper assets.
– Other assets which take a variety of forms, but are mainly
bank loans.
▪ Lending money in a foreign country can be in the form
of opening a bank account (loan to the bank), or
through other intermediaries (buying debt).

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The Financial Account (7 of 9)
• Some types of asset flows are more volatile than others.
– Volatility: how easy or hard it is for the flow to reverse.
– Volatile inflows can increase risk: It is easier for them to
become outflows. This puts a variety of pressures on the
country experiencing sudden, large outflows, or a sudden
stop in capital inflows.
• FDI is considered the least volatile of financial flows.
– Assets are businesses, real estate, factories, and it is takes
time to sell them and convert to a liquid asset that can be
moved easily.
– Also, they represent a commitment on the part of the
investor.

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The Financial Account (8 of 9)
The U.S. Financial Account, 2019 Billions of dollars
1.Net U.S. acquisition of financial assets (net increase in 427
assets/financial outflow )
1a.Direct investment assets 198

1b. Portfolio investment assets 39

1c. Other investment assets 189

1d. Reserve assets 5

2.Net U.S. incurrence of liabilities, excluding financial 784

derivatives (net increase in liabilities/financial inflows )
2a.Direct investment liabilities 311

2b. Portfolio investment liabilities 232

2c. Other investment liabilities 242

3.Net change in financial derivatives -38

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The Financial Account (9 of 9)
• Reserve assets are monetary gold and foreign currency that
can be used to settle international payments.
– All countries hold reserves as an emergency fund for
making payments.
– Reserve assets cannot create liabilities, hence they are not
symmetrical like the other assets.
• Financial derivatives are a special class of assets that have a
value derived from another asset.
– Example: A firm buys an option to buy dollars in the future
at a set price.

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The Limits on Financial Flows (1 of 2)
• During the Bretton Woods era, from 1945 to 1973, countries
limited capital flows that were solely to purchase or sell
financial assets.
– The IMF encouraged countries to allow capital flows to
finance the current account.
• After the break up of Bretton Woods, countries gradually
began to allow freer capital movements. This trend gained
speed in the 1980s and 1990s.

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The Limits on Financial Flows (2 of 2)
• Economists were divided on the issue of allowing completely
free movement of financial capital.
– Pros: It supplements domestic savings and brings capital
for investment; it should add to growth.
– Cons: Financial flows are not goods so trade theory does
not apply; they add to volatility and increase the risk of
financial crises.
• The recent financial crisis (2007-2009) and the Asian Crisis
(1997-1998) have caused there to be more caution and less
support for the idea of completely open capital markets.

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Case Study: The Crisis of 2007-2009
(1 of 3)
• The financial crisis began in 2007 and intensified in
September, 2008 when the large U.S. investment bank
Lehman Brothers collapsed.
• As the crisis developed, financial interests in the U.S.
reassessed their portfolios in order to reduce their risks.
– Sold foreign assets: Net purchases of $1.5 trillion in 2007
became net sales of $309 billion in 2008.
– Increased their reserves of highly liquid, low risk, dollar
denominated assets such as U.S. Treasury bills.
– Less change in FDI; most of the change was in portfolio and
other assets, including loans to foreign interests.

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Case Study: The Crisis of 2007-2009
(2 of 3)
• Financial and other firms abroad wanted to reduce their
exposure to U.S. assets and needed to accumulate highly
liquid, safe assets denominated in their own currencies.
– Cut down on their acquisition of U.S. assets: Fell from
$2.18 trillion in 2007 to $454 billion in 2008.
– FDI barely changed;
– Portfolio investment fell but still showed net new purchase
of U.S. assets;
– Other investment became disinvestment: A net sale of
bank accounts, loans, and other investments.

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Case Study: The Crisis of 2007-2009
(3 of 3)

The U.S. Financial Accounts, 2007-2008 Billions of dollars, Billions of dollars,

2007 2008
1. Net acquisition of financial assets 1,573 -309
1a. Direct investment 533 351
1b. Portfolio investment 381 -284
1c. Other investment 659 -381
1d. Reserve assets 0 5
2. Net incurrence of liabilities 2,182 454
2a. Direct investment 340 333
2b. Portfolio investment 1,157 524
2c. Other investment 687 -402

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National Income and Product Accounts
(1 of 3)

• The national income and produce accounts (NIPA) are used

to track domestic income and production.
• The central concept is gross domestic product (GDP): The
market value of all final goods and services produced inside a
country’s borders over a period of time, usually one year.
• Gross national product (GNP) is the market value of all final
goods and services produced by the country’s labor, capital,
and resources, during a year.

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National Income and Product Accounts
(2 of 3)
• GNP and GDP are closely related:
GNP = GDP + income received from abroad - income paid to
foreigners + transfers received from abroad - transfers made
abroad;
• Alternatively, using the concepts in the current account:
GNP = GDP + net primary income + net secondary income.

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National Income and Product Accounts
(3 of 3)

Variable Definition Variable Definition

GDP Gross domestic product X Exports
GNP Gross national product M Imports
C Consumption CA Current account
I Investment S Savings
G Government T Net taxes

• S is savings by households and firms;

• T is net taxes, equal to taxes paid minus transfers received;
• The budget balance for all of government is T – G.

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The Current Account and the
Macroeconomy (1 of 6)
• We can define: GDP = C + I + G + X – M.
• GNP = GDP + net primary income + net secondary income; or
• GNP = C + I + G + X – M + net primary income + net secondary
income; or
• GNP = C + I + G + CA.

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The Current Account and the
Macroeconomy (2 of 6)
• We can also define: GNP = C + S + T;
– This looks at GNP from the perspective of income
recipients: They can consume, save, and pay taxes.
• Setting the two definitions of GNP equal to each other: C + I +
G + CA = C + S + T; or

S + (T – G) = I + CA.

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The Current Account and the
Macroeconomy (3 of 6)
• The accounting identity S + (T – G) = I + CA, says:
Private savings + public savings
= domestic investment + foreign investment.
• This shows the relationship between:
– Budget deficits and trade (current account) deficits
– Overall savings and investment in an open economy that
trades;
– Foreign and domestic investment;
– Private and public savings.

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The Current Account and the
Macroeconomy (4 of 6)
• The relationship S + (T – G) = I + CA lets us infer several points:
– Countries with large budget deficits (T – G < 0) or low savings
rates will have less investment, ceteris paribus.
– A current account deficit lets us invest more and/or run budget
deficits.
– Countries that try to eliminate a current account deficit have to
cut investment, or cut consumption (raise S), or raise taxes, or
cut government spending, or some combination. All of those
reduce demand and push towards slower growth, ceteris
paribus.
– Private savings has several jobs: finance the budget deficit, if
there is one, and provide funds for investment at home and
abroad.

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The Current Account and the
Macroeconomy (5 of 6)
• During the financial crisis:
– Savings increased as consumers and businesses worried
about their solvency;
– Investment declined as businesses cut back due to weak
demand for their goods and services;
– Budget deficits soared as tax revenue fell and expenditures
increased;
– The current account moved towards balance as consumers
and businesses bought less from abroad.

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The Current Account and the
Macroeconomy (6 of 6)

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Are Current Account Deficits harmful?
(1 of 2)

• Current account deficits can be harmful:

– If a country is dependent on volatile foreign capital inflows
to finance them;
– If there is a sudden stop in foreign financing that forces
large cuts in spending and consumption.
– If they undermine confidence in the country and its
currency.
– If countries incur liabilities that must be paid back in a
foreign currency.

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Are Current Account Deficits Harmful?
(2 of 2)

• But they can sometimes be a sign of economic strength:

– If they are caused by large inflows of foreign capital,
looking for a place to invest;
– If they are caused by a rise in imports when an economy
experiences rapid economic growth.
• There is no exact threshold for when a deficit becomes
dangerous, but for most countries, when they reach 3-5% of
GDP, it is in the danger zone.

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Case Study: Current Account Deficits in
the U.S. (1 of 2)
• The United States current account experienced large deficits
in the 1980s and from the early 1990s forward (Figure 9.1)
– The deficits look similar but movements in private savings,
the budget deficit, and investment are different.
▪ Early deficit of the 1980s was driven by low private
savings and high budget deficits.
▪ Later deficit of the 1990s was during a period of falling
budget deficits, but falling savings and rising
investment.

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Case Study: Current Account Deficits in
the U.S. (2 of 2)
• During the 2000s, the current account deficit increased, 2001-2006.
– 3-5% of GDP, normally a warning sign.
– Foreign capital flowed to the U.S. from China, Germany, Saudi Arabia, and other current account surplus nations.
▪ Capital was available at low interest rates for investment, including new home construction.
• In 2007, the current account deficit begins to shrink.
– Increasingly rapid fall in the size of the deficit after the financial crisis begins.
– Rising savings rates and less consumption and investment led to a smaller deficit despite of the rise in government budget
deficits.

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International Debt (1 of 2)
• Net capital inflows are an increase in liabilities to foreign
nations.
– The inflows can take several forms: FDI, portfolio
investment, bank loans and others.
– Some forms represent an increase in debt by the home
country to foreigners.
▪ External debt creates debt service obligations.
• The burden of external debt depends on a number of factors.
– Its size relative to GDP;
– Whether denominated in home or foreign country
currency;
– The size of the current account deficit and the need for
continued capital inflows.
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International Debt (2 of 2)
• Debt can become unsustainable when:
– Debt service increases faster than GDP;
– Debt is denominated in a foreign currency and the
borrowing country has a significant decline in the value of
its own currency;
– A borrowing country depends on exports of 1 or 2
commodities that have falling prices in the world market.
• The Highly Indebted Poor Countries (HIPC) is a World Bank
program to offer debt relief to the most indebted, poorest
countries.

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Case Study: Odious Debt
• Odious debt is defined as debt incurred without the consent
of the citizens of the nation and is spent in ways that do not
benefit them.
– Associated with corrupt governments, dictatorships.
• Many HIPC countries have odious debt.
• Economists are divided on debt relief:
– Con: Moral hazard arguments against bailouts.
– Pro: Humanitarian concerns for extremely poor countries
where per capita incomes are around $900 per person per
year; growth is impossible with debt service burdens.

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The International Investment Position
(1 of 2)

• International investment position: Value of foreign assets

owned by home country minus the value of domestic assets
owned by foreigners.
• International investment position of the U.S.:
Domestically owned foreign assets – foreign owned domestic
assets
= $29,317 billion - $40,308 billion = -10,991 billion

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The International Investment Position
(2 of 2)
• Current account surpluses add positive balances to the
International investment position; deficits subtract.
– The large deficit in the U.S.’ international investment
position is the consequence of large current account
deficits in the 1980s, 1990s, 2000s.
• Deficits in the current account enable countries to invest
more, and can lead to technology transfers, among other
benefits.
– Technology transfer is usually embodied in FDI and can be
very helpful to developing countries that are inside the
frontier of technology and management.

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