Question

(Related to the Don't Let This Happen to You on page 1033) In 2016, Germany had a balance of trade surplus of \(€ 253\) billion and a current account surplus of \(€ 266\) billion. Explain how Germany's current account surplus could be larger than its trade surplus. In \(2016,\) what would we expect Germany's balance on the financial account to have been? Briefly explain.

Short answer

Germany's current account surplus could be larger than its trade surplus because besides trade, the former also includes net income from abroad and net current transfers, which might be positively weighted. Given the current account surplus, we would expect Germany's balance on the financial account in 2016 to be in deficit, since the surplus was likely invested abroad.

Step-by-step solution

Understanding Balance of Trade and Current Account

Balance of trade is the difference between a nation's exports of goods and services and its imports. A positive balance of trade indicates a surplus, meaning exports exceed imports. Current account, meanwhile, is a broader measure that includes the balance of trade, net income from abroad (such as interest and dividends), and net current transfers (like foreign aid). A surplus in current account means that the nation receives more money from these sources than it spends.

Explaining Larger Current Account Surplus

Even if a country's balance of trade shows a surplus, the current account may show an even larger surplus. This is possible when the net income from abroad and net current transfers are positive, meaning that the country receives more in these terms than it spends. In Germany's case, it indicates that apart from exporting more goods and services than it imported, Germany also received more income from abroad and/or current transfers. This leads to a larger surplus in the current account as compared to the balance of trade.

Determining Financial Account Balance

The financial account is a component of a country's balance of payments, recording investments in businesses, real estate, or the purchase of securities in another country. In principle, when a country has a current account surplus, it should expect to see a deficit on the financial account. This is because a current account surplus means that the country has received more money than it has spent in terms of trade, income from abroad, and current transfers. This surplus of foreign exchange tends to be invested abroad, leading to a deficit in the financial account. Considering Germany's situation in 2016, one would then expect a financial account deficit.

Key concepts

Balance of Trade

The balance of trade forms the core of a country's economic interactions with the rest of the world. It is the difference between the monetary value of exports and imports of a country's goods and services. When a country exports more than it imports, it has a trade surplus. Conversely, if it imports more than it exports, it faces a trade deficit.

For students grappling with these concepts, consider the simple analogy of a lemonade stand. If the stand sells more lemonade to passersby (exports) than it purchases lemons and sugar from suppliers (imports), it will have a surplus. This surplus is crucial, as it often infers that the country's economy is producing goods efficiently and competitively on the global stage.

Financial Account Balance

The financial account is part of a nation's balance of payments, documenting transactions that change the ownership of international assets. These include investments such as property purchases and sales, as well as stocks and bonds. A financial account balance can be in surplus or deficit, similar to a balance of trade.

A surplus indicates that a country is investing more abroad than other countries are investing in it. Imagine this as a game of Monopoly, where one player is buying properties on foreign squares more frequently than others are buying on their squares. Typically, if a country has a current account surplus, the financial account will show a deficit, as excess funds from the surplus are often used to invest in foreign assets.

Net Income from Abroad

Net income from abroad captures the flow of profits, interest, and dividends a country earns through its foreign investments minus payments made to foreign investors. If a country receives more income from its overseas investments than it pays out to foreign investors, it results in a net income surplus from abroad.

For instance, if German companies own factories in other countries, the profits from these factories contribute to Germany's net income from abroad. When German residents save money in foreign banks and earn interest, that interest is also part of this net income. To visualize, think of someone renting out several apartments in different countries; the rent they collect is akin to net income from abroad.

Net Current Transfers

Net current transfers are unilateral transfers with no quid pro quo, meaning there's nothing provided in return. These include foreign aid, remittances sent by residents working abroad to families in their home country, and pension payments across borders.

A surplus in net current transfers indicates that a country receives more from these types of transfers than it sends out. Picture this as receiving gifts or allowances from relatives living abroad; the money you receive contributes to your personal 'net current transfers'. It's a one-way flow that, when positive, enhances a country's current account surplus.