AP Macro: Unit 7
“The Open Economy:
International Trade and Finance”
Balance of Payments
In a closed economy,
economists keep track
of transactions with
the national income
account (GDP).
In an open economy,
(with international
trade) they keep track
with the “balance of
payments accounts.”
Balance of Payments
Definition: a summary
of a country’s
transactions with
other countries
Example: The Ryan family farm
• $100,000 revenue from selling rhubarb
• Spent $110,000 on purchase of machinery,
buying food, paying bills, etc.
• Received $500 in interest on bank account,
but paid $10,000 interest on mortgage
• Took out a $25,000 loan for farm
improvements
The Ryan Financial Year
• Cash: spent $110,000; made $100,000
Net -$10,000
• Interest: spent $10,000; made $500
Net -$9,500
• Loans/Deposits: borrowed $25,000;
deposited $5,500 after covering losses Net
$19,500
• Balance $0
The Ryan’s Financial Year
Sources of cash
Purchases/sales of G&S
Rhubarb sales:
$100,000
Interest Payments
Bank acct revenue:
$500
Loans/deposits
New loan: $25.000
Total
$125, 500
Uses of cash
Net
Expenses: $110,000 ($10,000)
Mortgage: $10,000
($9,500)
Bank deposit: $5,500 $19,500
$125,500
$0
Balance of Payments
• When a U.S. resident sells a good, such as
wheat, to a foreigner, that’s the end of the
transaction.
• But a financial asset, such as a bond, is
different. That sale creates a liability in the
future.
• The balance of payments accounts distinguish
between transactions that create liabilities
and those that don’t.
Current Account
• Transactions that don’t create liabilities are
part of the current account
• This is primarily the balance of payments on
goods and services
• The difference between the value of exports
and the value of imports (in Unit 2 we called
this “net exports”)
Financial Account
• Transactions that involve the sale or purchase
of assets, and therefore create future
liabilities, are part of the financial account
(we used to call this the capital account)
Current / Financial Account
• General Rule: Current Account + Financial
Account = 0
• The sources of cash must equal the uses of
cash
• Remember the circular flow: one person’s (or
country’s) expenses are another person’s (or
country’s) income
Payments to the rest of the world for assets
Payments to the rest of the world for G&S
(negative component of U.S. current acct)
Rest of World
United States
Payments to the United States for G&S
(positive component of U.S. current acct)
Payments to the United States for assets
The U.S. Balance of Payments in 2008 (billions of dollars)
Sales/ purchases of G&S
Factor income
Transfers
Current Account Balance
Gov't Asset
sales/purchases
Private asset
sales/purchases
Financial Account Balance
Payments from
foreigners
$1,827
$765
Pmts to
foreigners
$2,523
$646
$487
$530
($43)
$47
($534)
$581
$538
Total
Note: -$167 is just a statistical error. Not bad when managing $3.5T!
Net
($696)
$119
($128)
($705)
($167)
Review Q: The current account plus the
financial account is equal to:
a.
b.
c.
d.
e.
Zero
One
The trade balance
The size of the trade deficit
Sorry, I’ve been napping.
Financial Account
• Measures capital inflows from foreign savings
that become available for domestic
investment
• Which brings us back to our good friend: the
market for loanable funds
• Let’s look at the loanable funds market in two
economies: Shieldsville and Mocabeetown