Chapter 16
Payments among Nations
Overview
This chapter begins the discussion of international finance and macroeconomics—the subject of
the rest of the book. Its major purpose is to show how the balance of payments accounts for
international transactions and how the different balances (or sub-balances) can be interpreted. It
also presents the international investment position.
A country’s balance of payments records all economic transactions between the residents of the
country and residents of the rest of the world. Each transaction or exchange results in two
opposite flows of value. By convention, a credit or positive item is the flow for which the
country is paid—it is the item that the country gives up in the transaction, and it sets up a claim
on the foreign resident, so that funds (or “money”) flow into the country. A debit or negative item
is the flow that the country must pay for—it is the item that the country receives in the
transaction, and it sets up a foreign claim on a resident of the country, so that funds (or “money”)
flow out of the country.
Each transaction has both a credit and a debit item—double-entry bookkeeping—at least once
we create a fictional “goodwill” item for things that are given away (unilateral or unrequited
transfers). Therefore, if we add up all items for the country’s balance of payments, it must add up
to zero. What we find interesting about the balance of payments is not that it must completely
add up to zero, but rather how it does so. What are the values of different categories of items?
Typically, the first categories we examine are items that are international flows of goods (or
merchandise), services, income, and gifts—the current account. Services include flows of
transportation, financial services, education, consulting, and so forth. Income includes flows of
payments such as interest, dividends, and profits. In addition to the full current account balance,
we can also examine the goods and services balance.
The (private) financial account includes items that are nonofficial international flows of financial
assets. (Note that we use the name “financial account,” following the recently adopted standard
terminology, in place of the traditional name “capital account.”) Financial capital inflows are
credit items—capital or funds flow into the country as the country “exports” financial assets (by
increasing liabilities to foreigners or decreasing assets previously obtained from foreigners).
Financial capital outflows are debit items—capital or funds flow out of the country as the
country “imports” financial assets (by increasing the country’s assets obtained from foreigners or
decreasing its liabilities to foreigners). Direct investments are international capital flows between
units of a company located in different countries (Chapter 15 has a detailed discussion of foreign
direct investment and multinational firms). If the investor does not have management control,
international investments in stocks and bonds are usually called international portfolio
investments. Cross-border loans and bank deposits are other capital flows included in the
financial account.
The third and final major part of the country’s balance of payments records official international
flows of financial assets that serve as official international reserves. The country’s monetary
authority (usually, its central bank) undertakes these transactions. Official international reserves
include financial assets denominated in readily accepted foreign currencies, the country’s
holdings of Special Drawing Rights (SDRs), the country’s reserve position at the International
Monetary Fund (IMF), and gold.
If all items are recorded correctly, the sum of all of these items equal zero. In practice, they are
not and do not, so that a line called “statistical discrepancy” is added to make the accounts add to
zero. It represents the net of many items that are mismeasured or missed (net errors and
omissions).
The current account balance (CA) has several meanings. First, CA equals the value of the
country’s net flow (If) of foreign investments (both private and official). Second, CAequals the
difference between national saving and domestic real investment (S Id). Third, because CA is
approximately equal to the difference (X M) between the value of the country’s exports of
goods and services and the value of its imports of goods and services, CA is (approximately)
equal to the difference between domestic production of goods and services and national
expenditures on goods and services (Y E). The text shows how the current account and goods
and services balances have changed over time for four countries—the United States, Canada,
Japan, and Mexico.
The overall balance should indicate whether a country’s balance of payments has achieved an
overall pattern that is sustainable over time. While there is no perfect indicator of overall
balance, we often examine the country’s official settlements balance (B), which is the sum (CA +
FA) of the current account balance and the private financial account balance (including the
statistical discrepancy). The official settlements balance also equals the (negative of the) official
reserves balance (OR). Most of the official reserves flows indicate official intervention by the
monetary authorities in the foreign exchange market.
The international investment position is a statement of the stocks of a country’s foreign assets
and foreign liabilities at a point in time. The text shows that the United States has changed from
being an international debtor to creditor and back to a debtor during the past century.
“International Indicators Lead the Crisis” is the first box in a new serieson the euro crisis. The
box provides information on the current account balances and net international investment
positions for four countries—Greece, Portugal, Ireland, and Spain—at the center of the euro
crisis. Growing CA deficits and rising net debtor positions indicated increasing risk of a crisis.
Tips
A decision that an instructor must make is whether or not to cover the posting of individual
transactions to the credit and debit items. The discussion of posting of individual items is in
Appendix E. Chapter 16 itself focuses on using information from the balance of payments. We
believe that students generally can grasp the meaning of the balance of payments by focusing on
the various lines (showing types of items) and balances—as long as the students also see that it is
double-entry bookkeeping so that all items must add up to zero. Instructors who want their
students to see how individual transactions enter into the balance of payments should assign and
cover the material in Appendix E in conjunction with Chapter 16.
A good source of up-to-date information on many countries is Balance of Payments
Statisticsfrom the International Monetary Fund (IMF). The format for the current account is
similar to the presentation used in the text. What we call the financial account in the text is
actually the combination of the Financial Account and the Capital Account in the IMF
presentation method. In addition, the official reserves account shown by the IMF includes only
changes in official reserve assets held by the country’s own central bank or monetary authority.
The omission of changes in foreign official holdings of the country’s liabilities is not a major
issue for most countries, but it is important for a country like the United States, whose own
liabilities are held in large amounts by foreign central banks.