Lesson preview · Exchange rates and the balance of payments
The balance of payments and the current account
~7 min · Free to read
Mia lives in Country X. She orders a 400-dollar games console from a firm abroad. The same week, a tourist from abroad pays 150 dollars for a hotel room in Mia’s town. Mia’s money leaves the country. The tourist’s money comes in.
The balance of payments records every payment like these between a country and the rest of the world, over a period such as a year.
Key Term
Credits and debits
Follow the money, not the goods.
- A credit is money coming into the country. The tourist’s hotel bill is a credit for Country X.
- A debit is money going out. Mia’s payment for the console is a debit.
Mia’s lunch at a café in her own town doesn’t count: Mia and the café are both in Country X. What matters is who pays whom, not where. The tourist pays in Mia’s town but lives abroad, so the hotel bill counts.
Key Term
Three accounts
The current account records three kinds of payment:
- trade in goods (consoles, wheat, cars) and services (tourism, shipping, banking);
- income in both directions, such as profits a firm earns from its factory abroad, or interest it pays to foreign lenders;
- transfers: money sent with nothing in return, such as food aid, or money a worker abroad sends home. In 2024, Nepalis working abroad sent home money worth about a quarter of Nepal’s GDP (the value of everything Nepal produced that year).
The financial account records buying and selling assets: things people own, such as firms, shares, property and loans. When a foreign firm buys a factory in Country X, money comes in, so it’s a credit.
The small capital account records rarer items, such as a foreign government cancelling a debt. This lesson joins the last two as the capital and financial account.
Whatever the current account does, the capital and financial account does the opposite. An account is in deficit when more money goes out than comes in, and in surplus when more comes in than goes out. So a current account deficit of 60 billion dollars comes with a capital and financial account surplus of 60 billion. Together they add up to zero.
(Official tables add a line called “net errors and omissions”, because in practice the recorded figures rarely add up exactly.)
Trap · Common Misconception
"A current account deficit means the country is losing money"
Say Country X imports 20 billion dollars more than it exports. It can pay for the gap in two ways:
- selling assets: foreigners buy its firms, shares or property, or its central bank sells some of the foreign currency it holds;
- borrowing: foreigners lend to its firms or government.
The money comes back in on the capital and financial account.
A deficit can be fine if the money pays for factories or roads that raise future earnings. It’s riskier if the money pays for spending today: the country must repay what it borrows, and lenders may stop lending.
Trap · Common Misconception
"A current account deficit is a budget deficit"
A budget deficit means the government spends more in a year than it raises in taxes and other revenue. A current account deficit means the whole country (households, firms and government together) pays the rest of the world more than it receives from it.
In 2024, the governments of Germany and Japan both ran budget deficits. Yet both countries had current account surpluses, worth about 5.8% of GDP in Germany and 4.6% in Japan. The United States had both kinds of deficit at once.
Tip
The link to the exchange rate
The exchange rate is the price of one currency in terms of another. To pay for imports, people in Country X sell their currency for foreign currency. Foreign buyers of its exports do the opposite. If imports are far bigger than exports, people want to sell more of the currency than others want to buy. Unless foreign investors want the currency to buy assets in Country X, its exchange rate tends to fall. Country X’s exports then get cheaper abroad and its imports dearer, which can shrink the deficit.
Check yourself · no marks
Which account records each payment, and is it a credit or a debit for Country X? (1) A daughter working abroad sends her parents in Country X 300 dollars. (2) A firm in Country X buys a shop abroad for 2 million dollars.
Commit to one first. Guessing and being wrong beats reading the answer cold.
Worked Example
All figures are in billions of dollars. In one year, Country X exports 50 of goods and imports 68. It exports 20 of services and imports 12. Its net income from abroad is −3 (it pays out 3 more than it receives), and its net transfers are +1. Find its current account balance. What must its capital and financial account show?
Practice · 1 / 6
Which list best describes what the current account records?
Next
Like what you read?
Sign up free to save your progress, get spaced reviews tuned to you, and work through the whole course with interactive graphs and adaptive practice.