AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/6/6-1)
Unit 6 · Topic 6.1
6.1 Balance of Payments Accounts
The balance of payments records every transaction between a country and the rest of the world over a period of time. It has two parts: the current account, for trade in goods and services plus income and transfers, and the capital and financial account, for buying and selling assets. Every dollar that flows out has to come back somehow, so the two accounts add up to zero.
Key terms
- balance of payments (BOP)
- current account (CA)
- capital and financial account (CFA)
- balance of trade (net exports)
- credit vs. debit
- net unilateral transfers
Credits and debits
Each international transaction is recorded as a credit or a debit. Follow the payment, not the goods: a debit brings goods or assets into the country, but the money goes out.
- Credit: money flows into the country. Example: a Brazilian company buys U.S. software, so dollars come to the U.S.
- Debit: money flows out of the country. Example: an American buys a car made in Japan.
The current account (CA)
The current account records flows that aren't purchases or sales of assets. It has three parts. The current account can show a surplus or a deficit, and so can the balance of trade inside it.
- Net exports, also called the balance of trade: exports minus imports of goods and services. A trade deficit means imports are greater than exports.
- Net income from abroad: interest, dividends and wages residents earn from other countries, minus what foreigners earn here.
- Net unilateral transfers: one-way payments, such as gifts, foreign aid and money that workers send home to family abroad (remittances). Transfers sent out are debits; transfers received are credits.
The capital and financial account (CFA)
The capital and financial account tracks cross-border trades in assets: stocks, bonds, bank deposits, real estate and whole factories or companies. It also records some transfers of financial capital.
A CFA surplus means more financial capital is flowing in than out. A CFA deficit means more is flowing out.
Keep income and assets apart. Interest or dividends earned on an asset go in the current account as income. Buying or selling the asset itself goes in the CFA.
- A foreigner buying a U.S. asset, such as a U.S. Treasury bond or a factory in Ohio, is a credit to the U.S. CFA: a financial capital inflow.
- An American buying a foreign asset, such as shares of a German company, is a debit: a financial capital outflow.
Why the balance of payments balances
Every payment has to be financed. If the U.S. buys more goods and services from abroad than it sells (a current account deficit), foreigners end up holding the extra dollars. They use those dollars to buy U.S. assets, which creates a CFA surplus of the same size. So CA + CFA = 0.
- Current account deficit → CFA surplus of the same size (a net financial capital inflow).
- Current account surplus → CFA deficit of the same size (a net financial capital outflow).
Worked examples
Try each one yourself first, then open the solution.
- Example 1
Calculating the accounts
Country R's data for one year, in billions of dollars: exports of goods, 300; imports of goods, 380; exports of services, 90; imports of services, 60; net income from abroad, +15; net unilateral transfers, −10; foreign purchases of Country R's assets, 200; Country R's purchases of foreign assets, 155. Calculate the balance of trade, the current account balance and the capital and financial account balance.
Show the solutionHide the solution
- Step 1: Balance of trade = (300 + 90) − (380 + 60) = 390 − 440 = −50. Country R has a $50 billion trade deficit.
- Step 2: Current account = balance of trade + net income + net transfers = −50 + 15 − 10 = −45.
- Step 3: CFA = foreign purchases of R's assets − R's purchases of foreign assets = 200 − 155 = +45.
- Step 4: Check: CA + CFA = −45 + 45 = 0.
Answer: Balance of trade: −$50 billion. Current account: −$45 billion (a deficit). CFA: +$45 billion (a surplus).
- Example 2
Classifying transactions
For the U.S., say whether each transaction goes in the current account or the CFA, and whether it's a credit or a debit. (a) A U.S. farm sells soybeans to China. (b) A U.S. citizen buys a bond issued by the Mexican government. (c) A worker in the U.S. sends $500 to family in Guatemala. (d) A Japanese automaker builds a factory in Tennessee. (e) A U.S. investor receives dividends from shares in a French company.
Show the solutionHide the solution
- Step 1: (a) An export of goods: money flows in. CA credit.
- Step 2: (b) Buying a foreign asset: money flows out. CFA debit.
- Step 3: (c) A one-way transfer sent abroad: money flows out. CA debit.
- Step 4: (d) A foreign purchase of a U.S. asset: money flows in. CFA credit.
- Step 5: (e) Income earned on a foreign asset: money flows in. CA credit. The dividends are income, even though the shares themselves are assets.
Answer: (a) CA credit. (b) CFA debit. (c) CA debit. (d) CFA credit. (e) CA credit.
- Example 3
A deficit somewhere means a surplus somewhere else (classic trap)
A country has a current account deficit of $30 billion. A student says the country's balance of payments is $30 billion in deficit. Correct the statement.
Show the solutionHide the solution
- Step 1: The balance of payments is made of the CA and the CFA, and they sum to zero.
- Step 2: A $30 billion CA deficit must be matched by a $30 billion CFA surplus: foreigners are buying $30 billion more of the country's assets than its residents buy abroad.
- Step 3: So the CA is in deficit, but the balance of payments as a whole balances.
Answer: The CFA has a $30 billion surplus, so CA + CFA = 0; the balance of payments balances.
Common mistakes
- Putting the purchase of a foreign asset in the current account. Asset purchases go in the CFA; only the income they earn goes in the current account.
- Treating a debit as 'something coming in.' A debit means money flows out, even though the country gets goods or assets in return.
- Saying the whole balance of payments is in deficit. The CA and the CFA can each be in deficit, but together they sum to zero.
- Treating the balance of trade and the current account as the same thing. Net exports are only one of the current account's three parts.
On the exam
- Free-response questions may ask how a change, such as a rise in exports or a capital inflow, affects the current account or CFA balance. Say whether the balance increases or decreases, and why.
- When a question gives data, calculate the current account and the CFA separately, then check that they sum to zero.
Connected topics
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Check yourself
4 questions on 6.1 Balance of Payments Accounts. Pick an answer to see if you got it, and why.
A tourist from Japan pays for a hotel stay in Hawaii. How is this transaction recorded in the U.S. balance of payments?
A U.S. company builds a new factory in Mexico. How is this transaction recorded in the U.S. balance of payments?
An investor in Brazil buys U.S. Treasury bonds. How is this transaction recorded in the U.S. balance of payments?
A worker living in the United States sends money to her family in the Philippines. How is this transaction recorded in the U.S. balance of payments?
0 of 4 answered