 From a macroeconomic point of view, the main difference between an international

transaction and a domestic transaction concerns currency exchange. When people in

countries with different currencies buy from and sell to each other, an exchange of
currencies must also take place.
 The amount of trade between two countries depends on the exchange rate—the price of
one country’s currency in terms of the other country’s currency.
 If the Japanese yen were expensive (making the dollar cheap), both Japanese and Americans
would buy from U.S. producers.
 If the yen were cheap (making the U.S. dollar expensive), both Japanese and Americans
would buy from Japanese producers.
 Within a certain range of exchange rates, trade flows in both directions.
 Each country specializes in producing the goods in which it enjoys a comparative advantage,
and trade is mutually beneficial.

Balance of Payments
 Balance of payments—the record of a nation’s transactions with the rest of the world.
 A nation’s balance of payments is the sum of all the financial transactions that take place
between its residents and the residents of foreign nations.
 The large majority of these transactions fall into the two main categories: international trade
and international asset transactions.
 As a result, the majority of the items included in the balance of payments are things like
exports and imports of goods, exports and imports of services, and international purchases
and sales of financial and real assets.
 The balance of payments also includes international transactions that fall outside of these
main categories—things such as tourist expenditures, interest and dividends received or
paid abroad, debt forgiveness, and remittances made by immigrants to their relatives back
home.
 The balance of payments statement is organized into two broad categories The current
account given at the top of the table mostly deals with international trade. The capital and
financial account at the bottom of the table mostly deals with international asset exchanges.
 The balance of payments accounts are the record of a country’s international transactions.
 Foreign exchange is simply all currencies other than the domestic currency of a given
country
  A country’s demand for foreign exchange arises because its citizens want to buy things
whose prices are quoted in other currencies.
 The record of a country’s transactions in goods, services, and assets with the rest of the
world is its balance of payments.
 The balance of payments is also the record of a country’s sources (supply) and uses
(demand) of foreign exchange.

Current Account

 The balance of payments is divided into two major accounts, the current account and the
financial account.

Net export
 The first two items in the current account are exports and imports of goods.
 Exports earn foreign exchange for the country and are a credit item on the current account.
 Imports use up foreign exchange and are a debit item.
 Like most other countries, the United States buys services from and sells services to other
countries.
 The difference between a country’s exports of goods and services and its imports of goods
and services is its balance of trade.
 When exports of goods and services are less than imports of goods and services, a country
has a trade deficit.

Net foreign income from abroad (service account)

 Investment income: U.S. citizens hold foreign assets (stocks, bonds, and real assets such as
buildings and factories).
 Dividends, interest, rent, and profits paid to U.S. asset holders are a source of foreign
exchange.
 Conversely, when foreigners earn dividends, interest, and profits on assets held in the
United States, foreign exchange is used up.
 Transfer payments from the United States to foreigners are another use of foreign exchange.
 Some of these transfer payments are from private U.S. citizens, and some are from the U.S.
government.
 Many immigrants in the United States send remittances to their countries of origin to help
support extended families.
  Conversely, foreigners make transfer payments to the United States, which earns income for
the United States.

Net Unilateral Transfers

 Unilateral transfers are payments from one country to another that do not correspond to
the purchase of any good, service, or asset. Examples are official foreign aid (a payment from
one government to another) or a gift of money from a resident of one country to family
members living in another country.

Balance on current account

 Adding all the credit items and subtracting all the debit items in the current account yields a
number called the current account balance. If the current account balance is positive—with
the value of credit items exceeding the value of debit items—the country has a current
account surplus. If the current account balance is negative—with the value of debit items
exceeding the value of credit items—the country has a current account deficit.
 The balance on current account is the sum of income from exports of goods and services and
income from investments and transfers minus payments for imports of goods and services
and payments for investments and transfers.
 The balance on current account shows how much a nation has spent on foreign goods,
services, investment income payments, and transfers relative to how much it has earned
from other countries.
 When the balance is negative, a nation has spent more on foreign goods and services (plus
investment income and transfers paid) than it has earned through the sales of its goods and
services to the rest of the world (plus investment income and transfers received).
 exports have a plus (+) sign because they are a credit; they generate flows of money toward
the country.
 imports have a minus (-) sign because they are a debit; they cause flows of money out of the
country.
 A country’s balance of trade on goods is the difference between its exports and its imports
of goods. If exports exceed imports, the result is a surplus on the balance of goods. If
imports exceed exports, there is a trade deficit on the balance of goods.
 Net investment income represents the difference between (1) the interest and dividend
payments foreigners paid citizens and companies for the services provided by domestic
capital invested abroad (“exported” capital) and (2) the interest and dividends the citizens
and companies paid for the services provided by foreign capital invested here (“imported”
capital).
Financial account

 Capital and financial account consists of two separate accounts: the capital account and the
financial account.

 The capital account mainly measures debt forgiveness—which is an asset transaction

because the person forgiving a debt essentially hands the IOU back to the borrower.

 The financial account summarizes international asset transactions having to do with

international purchases and sales of real or financial assets.

 International transactions involving assets, either real or financial, are recorded in the capital
and financial account, which consists of a capital account and a financial account. The capital
account encompasses unilateral transfers of assets between countries, such as debt
forgiveness or migrants’ transfers (the assets that migrants take with them when they move
into or out of a country). The capital account balance measures the net flow of assets
unilaterally transferred into the country.

 Most transactions involving the flow of assets into or out of a country are recorded in the
financial account.

 When the home country sells an asset to another country, the transaction is recorded as a
financial inflow for the home country and as a credit item in the financial account of the
home country.

 When the home country buys an asset from abroad the transaction involves a financial
outflow from the home country and is recorded as a debit item in the home country’s
financial account because funds are flowing out of the home country.

 The financial account balance equals the value of financial inflows (credit items) minus the
value of financial outflows (debit items).

 When residents of a country sell more assets to foreigners than they buy from foreigners,
the financial account balance is positive, creating a financial account surplus.

 When residents of the home country purchase more assets from foreigners than they sell,
the financial account balance is negative, creating a financial account deficit.

 The capital and financial account balance is the sum of the capital account balance, the
financial account balance, and the net international flow of financial derivatives.
 In each period the current account balance and the capital and financial account balance
must sum to zero.
 CA + KFA = 0
 if a country has a current account surplus, it must have an equal capital and financial
account deficit.
 In turn, a capital and financial account deficit implies that the country is increasing its net
holdings of foreign assets.
 Similarly, a current account deficit implies a capital and financial account surplus and a
decline in the country’s net holdings of foreign assets.