Openness in Goods & Financial Markets

The Balance of Payments & External Accounts

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The balance of payments decomposes into current account (CA = NX + net income from abroad) and capital account (KA = net capital inflows). Identity: CA + KA + ΔR = 0. A CA deficit means the country is a net borrower from the rest of the world — KA must finance it. Net foreign assets evolve by CA: NFAₜ = NFAₜ₋₁ + CAₜ.

Derivation

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The BoP Identity

CA + KA + \Delta R = 0

Every transaction creates equal and opposite entries. Under floating FX, reserves are constant, so CA and KA are mirror images.

Components of the Current Account

CA = NX + \text{Net investment income} + \text{Net transfers}

| Component | Meaning | |-----------|---------| | $NX$ | Exports − imports of goods and services | | Net investment income | Dividends/interest earned abroad minus paid out | | Net transfers | Remittances, foreign aid |

The UK historically has $NX < 0$ but $CA \approx 0$ because its overseas assets generate large dividend/interest income. The CA is a better measure of "living within means" than $NX$ alone.

Stocks and Flows

The flow CA accumulates into the stock NFA:

NFA_t = NFA_{t-1} + CA_t + \text{Valuation}_t

Valuation effects can be large — when the dollar falls, the US's foreign-currency assets rise in value, improving NFA without any CA flows.

Global Imbalances

| Net debtor | Net creditor | |-----------|--------------| | US, UK, Australia | Germany, Japan, China |

These have been stable over decades, a feature of "global imbalances" discussions in policy circles.

Is a Deficit Bad?

Financing productive investment: increases future output → can service debt.
Financing consumption: future tax or devaluation required.
Intergenerational transfers: young debtor, old creditor is normal life-cycle.

Worked Example

Country with NFA = 0 runs CA = −50 billion per year for 10 years (no valuation effects).

Year 1: NFA = 0 + (−50) = −50 billion.
Year 2: NFA = −50 + (−50) = −100 billion.
After 10 years: NFA = −500 billion.
To finance, KA must equal +50 billion/year. Foreign capital inflows every year.

NFA falls from 0 to −500 billion over 10 years. Annual CA deficits of 50 billion accumulate into a 500 billion debt to the rest of the world.

Common Mistakes

—Confusing CA with NX — CA includes net investment income, which can be large.
—Ignoring valuation effects — NFA can move a lot without any CA flows.
—Assuming CA deficits are always bad — depends on what the borrowed funds finance.
—Forgetting the BoP identity: CA + KA must sum to −ΔR (essentially 0 under floating FX).

Exam Cues

→BoP identity: CA + KA + ΔR = 0. Under floating FX, CA ≈ −KA.
→CA = NX + net investment income + transfers.
→NFA stock follows CA flow + valuation effects.
→Net-debtor countries (US, UK) vs net-creditor (Germany, Japan, China).