Question

What is the relationship among the current account, the financial account, and the balance of payments?

Short answer

The current account, financial account, and balance of payments record a nation's economic transactions with the rest of the world. A deficit in the current account is financed by a surplus in the financial account and vice versa. The balance of payments, which equals to zero, is the sum of the current account and the financial account.

Step-by-step solution

Explain the Components

Firstly, recognize that the current account records a nation's transactions with the rest of the world for goods, services, income, and current transfers. This includes exports, imports, income earned on international assets, and international aid.

Financial Account Overview

Next, note that the financial account tracks the net change in ownership of national assets. It records investments in business, real estate and bonds, amongst others.

Link the Current and Financial Accounts

Now, you need to know that a deficit in the current account needs to be financed by a surplus in the financial account and vice versa. This means if a country's current account is in surplus, it is a net lender to the rest of the world, and if it's in deficit, it is a net borrower from the rest of the world.

Balance of Payments

Finally, the balance of payments, which is the broadest accounting of a nation's international transactions, is the sum of the current account and the financial account. This means that the balance of payments always balances, or in other words, it always equals zero, because it measures both sides of every transaction.

Key concepts

Current Account

The current account is a key component of a country's balance of payments. It records the flow of goods and services across borders. It also includes income and current transfers. Think of the current account as a summary of a nation's trading actions with other countries.

To better understand, consider the following elements:

• Goods and Services: This part accounts for exports (goods sent to foreign countries) and imports (goods received from other countries).
• Income: It involves earnings from foreign investments and payments made to foreign investors.
• Current Transfers: These are financial transactions where neither goods nor services are received in return, such as foreign aid or remittances.

When a country exports more than it imports, it has a current account surplus. This indicates the nation provides more goods and services than it receives. Conversely, a deficit suggests the opposite, wherein the country depends on external goods, services, or income.

Financial Account

The financial account is another vital component of the balance of payments. It captures the changes in ownership of international assets. Essentially, the financial account reflects investments made by a country in foreign lands and vice versa.

Consider these key parts:

• Foreign Direct Investment (FDI): Long-term investments where individuals or companies invest in a foreign country's business operations, like factories or offices.
• Portfolio Investment: Investments in financial assets such as stocks and bonds abroad.
• Other Investments: This includes loans, bank deposits, and other forms of credit between countries.

If a nation is importing more than it can pay for, it might need help financing the difference through investments from abroad, captured in the financial account. This interconnectivity means the financial account helps balance out the current account deficit or surplus.

International Transactions

International transactions are the backbone of global economic interaction. They encompass a wide variety of exchanges between countries. Every transaction with the international community reflects in the balance of payments.

Important components include:

• Trade: This involves exports and imports of goods and services.
• Capital Flows: Including both direct investment and portfolio investment, these reflect the flow of money for investment purposes.
• Transfers: Non-commercial transfers of money, such as remittances and foreign aid.

All these transactions collectively help maintain the equilibrium in a country's balance of payments. They ensure a country can afford what's necessary from abroad and manage its investments. The interactions occurring through international transactions reflect both economic policy and international relations dynamics.