Balance of Payments Review for AP Economics

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By — McGraw-Hill Professional
Updated on Mar 4, 2011

Review questions for this study guide can be found at:

International Trade: Review Questions for AP Economics

Main Topic: Balance of Payments Accounts

If Japanese citizens wish to purchase U.S. soybeans, the Japanese must pay in dollars. If U.S. citizens wish to buy Spanish olives, the Americans must pay in euros. Before goods can be exchanged between foreign trading partners, the currency of the importing nation must first be converted to the currency of the exporting nation.

Balance of Payments Accounts

When American citizens and firms exchange goods and services with foreign consumers and firms, payments are sent back and forth through major banks around the world. The Bureau of Economic Analysis tracks the flow of goods and currency in the balance of payments statement. This statement summarizes the payments received by the United States from foreign countries and the payments sent by the United States to foreign countries. Table 17.2 summarizes the main components of a hypothetical balance of trade for 2005.

Current Account

The current account shows current import and export payments of both goods and services. It also reflects investment income sent to foreign investors and investment income received by U.S. citizens who invest abroad. For example, if a Canadian is receiving dividends from an American corporation or interest from a U.S. Treasury bill, these dollars would be sent out of the country. After accounting for all of the payments sent to foreign countries and payments received from foreign countries, the balance on the current account in 2005 was –$26. A deficit balance such as this tells us that the United States sent more American dollars abroad than foreign currency received in current transactions.

Capital (or Financial) Account

When a nation buys a foreign firm, or real estate or financial assets of another nation, it appears in the capital account. For example, if a Swedish firm buys a manufacturing facility in Idaho, or if a Mexican citizen buys a U.S. Treasury bond, it is recorded as an inflow of foreign capital assets into the United States. If an American firm buys a ship-building company in Turkey, it would be an outflow of assets to foreign nations. A surplus balance of $11 tells us that there was more foreign capital investment in the United States than there was U.S. investment abroad.

Official Reserves Account

The Federal Reserve holds quantities of foreign currency called official reserves. When adding the current account and the capital account, if the United States has sent more dollars out than foreign currency has come in, as in the hypothetical example above, there exists a balance of payments deficit. In this case the Fed credits the account so that it balances. This is similar to taking money from your savings account to make up for an over-drafted checking account. If the current and capital account balances are positive, more foreign currency was coming into the United States than American dollars flowed abroad.

With this balance of payments surplus, the Fed transfers the surplus currency back into official reserves.

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