Chapter 9: Trade and the Balance of Payments

Class Notes: these count for 1% of your total grade

1. Definitions

Current Account:
The current account is a broad accounting record of a nation's ongoing, nonfinancial transactions
with the rest of the world. It includes:
+ Goods and Services Trade: Exports and imports of goods and services.
+ Primary Income: Earnings from investments and compensation of employees working abroad
(e.g., interest, dividends, wages).
+ Secondary Income: Transfers where no good or service is exchanged, such as foreign aid,
remittances, and other unilateral transfers.

Financial Account:
The financial account is the main record of financial flows between countries and covers all
types of financial assets that can be bought and sold internationally. It is divided into three main
categories: Net Acquisition of Financial Assets, Net Incurrence of Liabilities and Changes in
Financial Derivatives. The financial account presents the flow of assets during the year and not
the accumulated stock of assets. It measures net changes, which are the differences between
assets sold and assets bought. Payments made abroad to buy financial assets are recorded as
debits, while payments received from abroad for selling home country assets are recorded as
credits. The balance of the financial account indicates net lending (positive) or net borrowing
(negative).

Capital Account:
The capital account of the balance of payments records specialized capital transfers between a
nation and the rest of the world. It measures transfers rather than purchases or sales of assets,
making it somewhat similar to the category of secondary income in the current account, but
specifically related to capital transfers rather than income transfers. The capital account typically
includes relatively infrequent activities such as: Transfer of military bases or embassies between
countries. The capital account is usually a small item within the balance of payments.

Current Account Balance:

The current account balance is the net value derived from the current account. It represents the
difference between the total credits and debits recorded in the current account. Specifically:
+ Surplus: If the total value of credits (exports of goods and services, income received, and
transfers received) exceeds the total value of debits (imports of goods and services, income paid,
and transfers paid), the country has a current account surplus.
+ Deficit: If the total value of debits exceeds the total value of credits, the country has a current
account deficit.
The current account balance reflects the difference between a nation's savings and its investment,
showing whether a country is a net lender or borrower to the rest of the world. A positive current
account balance indicates a surplus, where a country is a net lender, while a negative balance
indicates a deficit, where a country is a net borrower.

Trade Deficit:
A trade deficit occurs when a country's imports of goods and services exceed its exports of goods
and services. It represents a negative trade balance. In other words, the value of what a country
buys from other countries is greater than the value of what it sells to them.
For example, if a country imports $3,114 billion worth of goods and services but only exports
$2,498 billion, the trade deficit would be $616 billion. This negative balance indicates that the
country is spending more on foreign products and services than it is earning from its own
exports.

Trade Surplus:
A trade surplus occurs when a country's exports of goods and services exceed its imports of
goods and services. It represents a positive trade balance. In other words, the value of what a
country sells to other countries is greater than the value of what it buys from them. For example,
if a country exports $2,498 billion worth of goods and services and imports $3,114 billion, a
trade surplus would occur if the export value were higher than the import value. A trade surplus
indicates that the country is earning more from its international trade than it is spending on
imports.

Statistical Discrepancy:
Statistical discrepancy in the context of a nation's balance of payments refers to the difference
between the net lending or borrowing reported in the financial account and the sum of the current
and capital accounts. It is essentially the residual amount that reconciles discrepancies between
these accounts due to measurement errors or data inaccuracies. the statistical discrepancy
accounts for the imbalance that arises when the total recorded transactions in the current and
capital accounts do not exactly match the recorded financial transactions. This discrepancy
reflects the imperfections in data collection and reporting, and it ensures that the balance of
payments accounts remain balanced despite these inconsistencies.

2. Provide the correct order to find the current account balance (i.e. goods exports +
services exports – goods…)
The order to calculate the current account balance is:
Current Account Balance=(Goods Exports+Services Exports)−(Goods Imports+Services Import)
+(Investment Income Received−Investment Income Paid)+(Compensation of Employees Receiv
ed−Compensation of Employees Paid)+(Transfers Received−Transfers Made)

3. When is a country in a current account surplus?

A country is in a current account surplus when the value of its total exports of goods and
services, along with its net primary and secondary income, exceeds the value of its total imports
of goods and services and its outgoing primary and secondary income payments. In other words,
a country is in a current account surplus if:
Current Account Balance > 0
This indicates that the country is a net lender to the rest of the world, as it is earning more from
its international economic transactions than it is spending. Specifically, the components
contributing to this condition are:
- Goods Exports: Higher exports of goods than imports.
- Services Exports: Higher exports of services than imports.
- Primary Income: More income earned from abroad (investment income and
compensation of employees) than paid to foreign entities.
- Secondary Income: More transfers received from abroad (such as remittances and foreign
aid) than sent abroad.

4. Provide the correct order to determine the financial account balance

To determine the financial account balance, follow these steps:
a. Net U.S. acquisition of financial assets, excluding financial derivatives (increase/outflow
(+)):
o This measures the value of financial assets (such as bank accounts, stocks, bonds,
real estate, etc.) acquired by the U.S. residents from foreign entities.
 o Example: If U.S. residents purchase foreign assets worth $427 billion, this value
is recorded.
b. Net U.S. incurrence of liabilities, excluding financial derivatives (increase/inflow (+)):
o This measures the value of financial assets sold by U.S. residents to foreign
entities.
o Example: If U.S. incurs $784 billion in liabilities (foreigners purchase U.S. assets
worth this amount), this value is recorded.
c. Net change in financial derivatives:
o This measures the net change in the value of financial derivatives, which are
financial instruments derived from other assets.
o Example: If the net change in financial derivatives is -$38 billion, this value is
recorded.
d. Calculate the financial account balance:
o The financial account balance is calculated by summing the net acquisition of
financial assets, net incurrence of liabilities, and the net change in financial
derivatives.
o Formula: Financial Account Balance = Net U.S. acquisition of financial assets -
Net U.S. incurrence of liabilities + Net change in financial derivatives.
For instance, using the example values: Financial Account Balance=427−784+(−38)=−395
Thus, the U.S. would have a financial account balance of -$395 billion

5. Provide the formula to determine the statistical discrepancy

To determine the statistical discrepancy, the formula is:
Statistical Discrepancy=Financial Account Balance−(Current Account Balance+Capital Account
Balance)
This formula accounts for any measurement errors or unrecorded transactions to ensure that the
balance of payments accounts sum to zero

6. Using savings, investment, taxes and government expenditures, provide a formula to

show how to calculate the current account balance.
To relate the current account balance to savings, investment, taxes, and government
expenditures, we can use the national income accounting identity. This identity helps to link
these macroeconomic variables.
The national income identity for an open economy is given by:
GDP = C + I + G + X – M
Where:
- C is the consumption
- I is the investment
- G is the government expenditures
- X is the exports
- M is the imports
Now, we also know that:
GNP = C + S + T
Where:
 S is the savings
 T is the taxes
From the two equations, we can rearrange and combine them:
C + I + G + CA = C + S + T
So the current account balance (CA) can be expressed as:
I + G + CA = S + T => CA=(S−I)+(T−G)

7. What scenarios arise to cause the current account to be in a deficit?

A current account deficit arises when a country imports more goods, services, and income than it
exports. This can occur due to high consumer spending on imports, weak export performance, or
strong domestic currency making exports expensive. Additionally, high investment relative to
savings or persistent government budget deficits can contribute to a deficit. Rapid economic
growth increasing demand for foreign goods and low global commodity prices for exporting
nations also play significant roles.