Balance of Payments

A nation’s balance of payments represents its economic transactions with the world. The balance of payments consists of two parts, the current account balance and the capital account balance, which must equal each other.

The current account balance is the nation’s current receipts minus its current expenditures. It includes:

1. Trade in goods in service, exports minus imports

2. Income receipts: on US assets abroad, or paid to foreigners for US assets

3. Net unilateral transfers, such as debt relief.

The capital account balance is the nation’s capital account inflows minus its capital account outflows. It includes:

1. Foreign direct investment, in which a US citizen partly owns and controls a company based in a foreign country, or vice versa

2. Portfolio investment: trading stocks on other nations’ exchanges

3. Checking accounts established abroad by US citizens, or in the US by foreigners.

By definition, the current account balance equals the negative of the capital account balance. This is because as US dollars flow out the country—for example, to import foreign goods—foreigners keep those dollars or invest them in US assets such as Treasury bonds; a decrease in the current account balance becomes a capital inflow of the same quantity. (Slides, Sept. 23)

Milton Friedman argued that governments have four ways to redress the balance of payments.

1. Counterbalancing changes in currency reserves. When governments face a surplus of their currency in the global market they can absorb it by having the monetary authority sell government bonds. Conversely, a government facing a shortage of currency can buy bonds to raise money circulation. Friedman argued that this was impractical because governments will frequently lack enough currency to carry out these policies.

2. Adjustment in the general level of internal prices and incomes. The central bank can use the interest rate to affect domestic prices and revenues, but Friedman assumed this option was politically unviable.

3. Allow flexible exchange rates. Governments can let their exchange rates adjust while preserving internal prices and incomes. According to Friedman this is the best approach.

4. Direct controls over transactions involving foreign exchange. Governments can influence the current account through restrictions like tariffs, and the capital account through controls like limits on currency exchange. Friedman believed that this type of government intervention impeded free trade, and thus growth.