2.1 Balance of payments structure and components

The balance of payments tracks a country's economic transactions with the world. It's split into current, capital, and financial accounts, each measuring different aspects of international economic activity. Understanding these components is crucial for grasping a nation's economic health and global position.

The current account reflects trade and income flows, while capital and financial accounts show changes in asset ownership. These balances impact national savings, investment, and overall economic stability. Surpluses and deficits in these accounts have far-reaching effects on currency values, debt levels, and global economic dynamics.

Balance of Payments Structure and Components

Balance of payments components

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• Balance of payments (BOP) records all economic transactions between a country's residents and the rest of the world over a specific period (usually a year)
• Key components include current account tracks trade in goods and services, capital account records capital transfers, and financial account covers investment flows
• Balancing item net errors and omissions accounts for statistical discrepancies ensures accounting balance
• Double-entry bookkeeping system records each transaction as credit and debit maintaining overall balance
• Reserve assets like foreign exchange reserves, gold reserves, and Special Drawing Rights (SDRs) used by central banks to manage currency fluctuations

Current vs capital vs financial accounts

• Current account encompasses trade in goods and services, primary income from investments, and secondary income like remittances
• Capital account covers capital transfers and transactions involving non-produced, non-financial assets (land rights, intellectual property)
• Financial account tracks direct investment, portfolio investment, other investment, and financial derivatives
• Key differences: current account involves ongoing economic activity, capital and financial accounts deal with asset ownership changes
• Time horizon varies: current account focuses on short-term flows, capital and financial accounts can have longer-term implications
• Impact on national wealth differs: current account directly affects GDP, capital and financial accounts influence asset composition

Current account and national savings

• National accounting identity $CA = S - I$ links current account balance (CA) to national savings (S) and investment (I)
• Savings-investment gap determines current account balance: surplus when S > I, deficit when S < I
• National savings influenced by private savings (household and corporate) and public savings (government budget balance)
• Investment affected by interest rates, economic growth expectations, and business confidence
• Current account balance reflects economy's net lending/borrowing position relative to the rest of the world

Economic impact of account balances

• Current account deficit indicates net borrowing from abroad potentially leading to external debt accumulation and currency depreciation pressures
• Deficit benefits include increased investment and access to foreign capital and technology but risks vulnerability to sudden capital flow stops
• Current account surplus signifies net lending to other countries resulting in foreign asset accumulation and potential currency appreciation
• Surplus implications include reduced domestic consumption or investment relative to production
• Policy considerations involve exchange rate management, fiscal and monetary policies, and structural reforms to address imbalances
• Long-term sustainability assessed through debt-to-GDP ratio and external debt servicing capacity
• Global imbalances impact international trade and capital flows potentially contributing to financial crises (2008 Global Financial Crisis)