Chapter 9
Trade and the Balance
of Payments
◼ Outline
Introduction: The Current Account
The Trade Balance
The Current and Capital Account Balances
Introduction to the Financial Account
Types of Financial Flows
Limits on Financial Flows
Case Study: The Crisis of 2007–2009 and the Balance of Payments
The Current Account and the Macroeconomy
The National Income and Product Accounts
Are Current Account Deficits Harmful?
Case Study: Current Account Deficits in the United States
International Debt
Case Study: Odious Debt
The International Investment Position
Appendix A: Measuring the International Investment Position
Appendix B: Balance of Payments Data
Appendix C: A Note on Numbers
58 Gerber • International Economics, Seventh Edition
◼ Learning Objectives
After studying this chapter, students will be able to:
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.
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.
◼ What Students Should Know after Reading Chapter 9
The accounting detail of Chapter 9 remains relatively aggregated, but students should become familiar
with the key subaccounts within the balance of payments and be able to classify transactions as credits or
debits. The study questions provide practice problems and frequent examples of similar questions.
It should be noted that U.S. balance of payments accounting was revised significantly in 2014, and the text
reflects these changes. Most notable, perhaps, is the change to “primary income” (largely income on
investments) and “secondary income” (remittances and aid). Students doing research may find older
versions of this system and thus should be familiar with the term “unilateral transfers”, the previous term
for secondary income.
Chapter 9 Trade and the Balance of Payments 59
The chapter includes an analysis of international debt. The notions of unsustainable debt and debt service
are important for students who are used to hearing nominal dollar figures and flows, if they have heard
anything about debt at all. The extension to debt forgiveness and the situation of Highly Indebted Poor
Countries rounds out the discussion of non-trade issues.
◼ Assignment Ideas
1. Students should be introduced to the data on the U.S. balance of payments available from the Bureau
of Economic Analysis at www.bea.gov. You may find it useful to provide data if the source is too
complicated for the students to navigate in a reasonable amount of time, and to ask them to write a
one- or two-page narrative describing the table. The goal is to encourage them to write like an
economic journalist and to show they understand the concepts by making them clear and accessible to
someone who has not studied this chapter.
2. Similarly, the IMF’s Balance of Payments Statistics is available in most research libraries and is a
very clear presentation of data for the most of the world’s nations. They provide both a detailed view
and a condensed view. Students should be able to navigate the condensed view without too many
◼ Answers to End-of-Chapter Questions
1. Use the following information to answer the questions below. Assume that the capital account is
equal to 0.
Exports of goods and services
500
Primary income received
Secondary income received
200
300
Imports of goods and services
700
Primary income paid abroad
300
Secondary income paid
100
Net acquisition of financial assets
300
Net incurrence of liabilities
400
Net change in financial derivatives
600
a. What is the trade balance?
b. What is the current account balance?
60 Gerber • International Economics, Seventh Edition
c. Does the financial account equal the current account plus the capital account balance?
d. What is the statistical discrepancy?
Answers:
a. The “trade balance” is 700–600 = 100. Note that this is really the balance on goods and services,
2. Look at each of the cases below from the point of view of the balance of payments for the United
States. Determine the subcategory of the current account or financial account that each transaction
would be classified in, and state whether it would enter as a credit or debit.
a. The U.S. government sells gold for dollars.
b. A migrant worker in California sends $500 home to his village in Mexico.
c. An American mutual fund manager uses the deposits of his fund investors to buy Brazilian
telecommunication stocks.
d. A Japanese firm in Tennessee buys car parts from a subsidiary in Malaysia.
e. An American church donates five tons of rice to the Sudan to help with famine relief.
f. An American retired couple flies from Seattle to Tokyo on Japan Airlines.
g. The Mexican government sells pesos to the United States Treasury and buys dollars.
Answers:
a. The United States “exports” official reserve assets; it is a credit in the financial account.
b. A resident of the United States transfers money to a foreign locale; it is a debit in the current
3. Weigh the pros and cons of a large trade deficit.
Answer: Trade deficits are generally considered a negative for a country, but the reality is more
subtle. On the negative side, large deficits signal that a country is accumulating foreign
debt that can be difficult to service if the excess imports are not used to enhance national
productivity. Furthermore, trade deficits require capital inflows. If foreign investors lose
Chapter 9 Trade and the Balance of Payments 61
Copyright © 2018 Pearson Education, Inc.
On the positive side, a large trade deficit can also signal that foreigners have confidence
in the current set of economic policies and the future prospects of the economy.
Furthermore, and most importantly, a large trade deficit and the attendant capital inflows
allow a higher level of investment than would be possible solely on the basis of domestic
savings.
4. Is the government budget deficit of a country linked to its current account balance? How so? Explain
how it is possible for the United States’ current account deficit to grow while the budget deficit has
disappeared, as happened in the 1990s.
Answer: The budget deficit and the current account are linked but there are the other variables of
domestic private savings and domestic investment that are also joined in the savings-
5. Compare and contrast portfolio capital flows with direct investment capital flows.
Answer: These two types of capital flows are similar in that they both provide a nation with the use
of foreign savings. That is, they both represent financial flows that are a net increase in
the amount of resources available for investment. On the other hand, they are very
6. Why is a current account surplus equivalent to foreign investment?
Answer: A current account surplus leads to the net accumulation of foreign assets, whether real or
financial. In either case, there is the prospect of a future stream of revenue that will be
generated from the assets.