Balance of Payments

A nation’s balance of payments is a complex set of accounts. There are three major accounts involved:

·         Current Account (aka Trade Account): Imports and exports of goods and services.

·         Capital Account: Records all trades which affect the amount of claims the nation has abroad, both for and against. Or in other words, all borrowing and lending activity.

·         Official Settlements Account: Records the changes in currency reserves held in all foreign currencies.

These three accounts sum to zero. The total import and export activity, plus the net effect of borrowing and lending, must equal the change in currency reserves. The term “balance of trade deficit” refers to the current account, and the term “balance of payments defecit” refers to the capital account. A balance of payments defecit can be thought of as the excess supply of a country’s currency—this is the amount of foreign currency that the government must buy if the exchange rate is to be preserved. If the government does not act, a defecit in this account will result in a currency devaluation.

The total value of world trade is more than 3 trillion dollars a year, but this is a small amount compared to the total value of worldwide currency trading. If currencly fluctuations only occurred as a result of trade, currencies would be quite stable. However, currencies are not stable, because fluctuations also occur due to currency trading that has nothing to do with goods or services trading. For example, if our interest rates are higher than another nation’s, then citizens (and fund managers) in the other nation can improve their returns by buying our currency. Expectations about the future appreciation or depreciation of our currency will also make it more or less attractive to buy. As a result, it is very difficult to predict how exchange rates will change with time. Note that the supply of our currency will affect these expectations and so the supply and demand of our currency are not entirely independent.