Lesson 6: The Balance of Payments Always Balances

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Download Lesson 6 Guide


  • Balance of payments
  • Capital account
  • Current account
  • Export
  • Import
  • Trade deficit
  • Trade surplus

Content Standards

Standard 5: Students will understand that: Voluntary exchange occurs only when all participating parties expect to gain.  This is true for trade among individuals or organizations within a nation, and among individuals or organizations in different nations.

  • A nation pays for its imports with its exports.

Lesson Overview

Balance of payments accounting is an often misused and misunderstood tool for keeping track of our economy’s flow of imports and exports.  While the data, itself, is neutral, it is sometimes reported in ominous tones, especially when the numbers total up to a deficit in the merchandise account.  As students learn more about trade, they appreciate that a trade deficit is not necessarily bad any more than a trade surplus is necessarily good.  This lesson reinforces their appreciation of that reality by identifying the components of the balance of trade.  Learning about the flow of financial assets captured in the capital account should add a whole new dimension to their understanding of the full scope of trade.  The accompanying classroom activity allows students to explore balance of payments accounting in a simplified example of trade among 3 states in the U.S.

Key Points:

Keeping the Ledger:  The Nuts and Bolts of Balance of Payments Accounting

  1. Balance of payments accounting is an accounting system used to measure international flows of money and products (goods, services, and resources).
    • Each exchange is assigned both a positive and a negative value:
      • Generally, a positive value (+) is assigned to exports—and that includes exports of money or other financial assets as well as exports of products.
      • Generally, a negative value (-) is assigned to imports—and that includes imports of money and other financial assets as well as imports of products
      • The actual accounting simply records the flows as they are measured over any specified time period.
  2. Balance of payments accounting differentiates between products (goods and services) and financial assets (money).
    • The Current account records the flows of goods and services.
      • Conversational use of the terms export and import usually refers to the Current account.
    • The Current account is further divided into Merchandise, Services, and Private and Government Transfers.
      • Historically, the most important category has been Merchandise – material stuff and things like cars, airplanes, wheat, clothing, iron ore, etc.
        • Generally, and somewhat misleadingly, conversational and news references to imports and exports have really been references only to the Merchandise account.
      • In the latter decades of the 20th Century and into the 21st, the service sector has been growing very quickly and is an increasingly important part of the Current account.
        • Examples of items in the service category are tourism, computer software, technical training (as when Boeing sends a flight training crew with the sale of new aircraft to a foreign country), concert entertainers, and organizational and financial services.
      • Private and Government Transfers are gifts or grants to foreign individuals, organizations, or governments.
        • Examples include hurricane disaster relief aid in Central America, individual Americans’ cash donations to African famine relief, or government humanitarian foreign aid to India.
    • The Capital account records the annual change in financial flows.
  3. The balance of payments always balances.
    • Goods, services, and resources traded internationally are paid for; thus every movement of products is offset by a balancing movement of money or some other financial asset.
      • If a U.S. retailer imports $1 million of Japanese televisions, there is a corresponding or balancing movement of money to the Japanese producer.
    • A surplus in the Current account is by definition offset by a deficit in the Capital account.
      • Another way to think of this is that if we export goods and services, then we import financial assets of the foreigners who purchased those goods and services.
    • Similarly, a deficit in the Current account must be offset by a surplus in the Capital account.
      • In practical terms, if Americans import foreign products, then we export our financial assets to pay for them.
    • While the Current account deficit of recent years has received much media attention, there is little public awareness that this trade deficit is accompanied by a surplus in the Capital account.
  4. The Capital account measures financial flows, or the change in the claims of one country on the assets of another.
    • When Americans purchase foreign goods, American money and other financial assets flow out of the country to foreigners.  (See Visual #3)
    • With a few notable exceptions (like oil), American money is only useful for American purchases.  So, we say that holders of American money have a claim on American assets.
      • Foreigners may hold these claims in a variety of forms, including:
        • Currency
        • Treasury bills and notes
        • Stock in U.S. companies
        • Government or Corporate bonds
      • Or, they could actually purchase American capital assets, like office buildings, ski resorts, business franchises, etc.  (Since they don’t move the assets to their home countries, we don’t count them in the current account.)
        • When foreigners purchase American products, foreign money and financial assets flow into the United States.  (See Visual #3)
      • In that situation, then, Americans hold claims on the assets of other countries.
        • In practical terms, this could mean owning part of a British company, investing in a French winery, buying stock in a Japanese automaker, or simply holding foreign currency.
  5. An example of a simple Balance of Payments account with a single nation.  (See Visual #1 in download file attached above.)
  6. The U.S. Balance of Payments with all trading partners: (See Visual #2 in download file attached above.)
  7. The realities of international trade mean that the balance of payments model is much more complex than simple exchange of money for finished products.
    • In the increasingly specialized global economy, the import and export of intermediate goods accounts for an ever-larger portion of trade data.
      • For instance, engine parts produced in Mexico are made into engines in Windsor, Canada, and shipped to Detroit where they become part of finished cars and then they are sold in Canada, France, Great Britain, and Germany.
      • Another complex example occurs when an American company builds a factory in another country.  Any flow of materials, parts, or finished goods between the U.S. parent company and the foreign factory must be counted in the import/export data.
  8. Interpreting the Data – Contrary to the impression we may receive from gloom-and-doom news reporting, balance of payments accounting simply offers us a number – a reporting of the aggregated record of trade flows. The significance of a deficit or surplus in either the Current Account (goods and services) or the Capital Account (financial flows or claims on assets) is the subject of ongoing debate because groups and individuals are affected differently by deficits and surpluses.  Without drawing conclusions about which is better from a policy standpoint, it is possible to use economic analysis to decipher the practical implications of various configurations in the balance of payments.
    • Current Account Surplus (and Capital Account Deficit): This configuration is favored by those who believe that we should always export more merchandise and services than we import.
      • This so-called trade surplus necessarily means a capital account deficit – an increase in U.S. holdings of claims on foreign assets.
        • In other words, we have sent more goods and services to other countries than they’ve sent to us, so we are holding their IOUs in the form of money or claims on their financial assets.
      • In practical terms, this configuration means that:
        • American goods and services are competitive and desired in world markets; foreigners are willing to spend their money on our products.
          • Owners and workers in export industries really like this situation.
        • Americans are willing to hold claims (IOUs) on foreign assets, in the form of foreign currency, stock in foreign companies, foreign bonds, etc.
          • This is ok if the countries whose IOUs we’re holding have strong, stable governments and economies, or products we think we’ll one day want.
  9. Neither Surplus Nor Deficit in the Current Account:  This configuration is favored by those who believe that our exports to a particular nation should always equal our imports from that nation.
    • This view presumes that there is some inherent value in an equilibrium position or that an equilibrium somehow equates to fair trade.  There is no evidence that either is the case.
    • The increasing complexity of global trade, based on comparative advantage and increasing specialization makes an equal exchange of goods and services between any two nations highly unlikely.
      • Most international trade is multi-lateral.
        • For example, while the U.S. runs merchandise deficits with Japan, it runs merchandise surpluses with the Netherlands.  At the same time, the United Arab Emirates runs merchandise surpluses with Japan and deficits with the U.S.
  10. Current Account Deficit (and Capital Account Surplus): This configuration is favored by those who believe that we are better off if we import more than we export.
    • In other words, we are buying more goods and services from other countries than they are buying from us, so they are holding IOUs in the form of American currency and other financial claims on assets.
    • In practical terms, this configuration means that:
      • Americans are enjoying foreign goods that are selling at prices below what they could be produced for in the U.S.
        • Owners and workers in import industries, and consumers in general, benefit in this situation.
      • The willingness of foreigners to hold claims on U.S. assets is a source of investment in American enterprises.
        • It is also an indication of foreign faith in the strength of the American economy and stability of American government.
  11. Nations don’t trade; people do.  Balance-of-payments accounting is simply the aggregated record of millions of individuals’ decisions about what to produce, sell, and consume.
    • Trade policy directed to changing the balance-of-payments does not have a uniform effect, but impacts the decisions and well-being of different individuals in different ways.
      • It should not be surprising, therefore, that trade policy is the focus of active, intense lobbying efforts on the part of industries affected by various configurations of deficit and surplus.
    • Policies designed to correct the balance of trade ignore the reality that Trade Creates Wealth.
      • Policy actions taken to correct or change levels of imports and exports invariably restrict trade flows.
      • While such policies may or may not successfully change the composition of the balance-of-payments categories, they almost assuredly decrease the overall volume of trade and thus inhibit the creation of wealth.

Lesson 6 ActivityBalance of Trade Among States

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