Hi. Welcome to Macroeconomics. This is Kate. This tutorial is on international trade. As always, my examples are in green and my key terms are in red.
So in this tutorial, I'll define for you and talk about the balance of payments and how it contains the current account and the capital account. We'll talk about trade surpluses and deficits and the impact that they have on our balance of payments.
OK, so if we're talking about international trade, what we're looking at is the flow of goods and services and also capital among countries. So this is not a new thing. It's been taking place throughout a whole lot of history, but it just seems like more and more every decade it's importance really increases. And there are political effects, social effects, as well as economic effects, of international trade.
What we're looking at here is how do we measure the economic impact of international trade on a nation. So one way is to measure the balance of payments. This involves comparing our demand and supply of foreign exchange or foreign currency basically. The balance of payments is a record of all monetary transactions that flow across a country's border. And like I said before, the two major components are the current and the capital accounts.
So let's talk about this idea of foreign exchange for a minute. Our demand for foreign exchange increases when we decide we want to buy stuff in other currencies. So for example, when Americans decide to go on vacation in Mexico, or an American decides to buy a German car, or an America decides to invest in stock issued by a Japanese company. In all of those situations, we would need to purchase the foreign currency, because we would need to supply our US dollars in order to purchase these things in those currencies, whether it's in the yen, the euro, or the peso.
Our supply of foreign exchange increases when we sell our stuff to foreigners. So when they do the same things in our country or for our stuff. So if European tourists come here to go to Disney World for example, they would need to purchase our currency with theirs. A Japanese businessman maybe flies on a US airline to do business here or go home or if a Canadian invests in General Motors stock-- all of those are situations where we would be increasing our supply of foreign exchange. So that'll come up later.
Let's look at the current account and the capital account, because that's what makes up this balance of payments. Let's start with the current account. This represents the sum of all recorded transactions, including traded goods and services, income, and transfer payments. So the current account is really the sum of our balance of trade. It shows how much a nation has spent on foreign goods, services, income, and transfer payments compared to how much it's earned in those things.
So one thing I want you to keep in mind is that exports, with the goods and services, are going to credit this account and lead to a surplus in the current account, whereas imports are going to debit this account, which means they would create a deficit in the current account. So some examples of the current account activities here-- we know what imports and exports are. That's when Americans sell or purchase foreign goods and services.
Americans also can, though, earn investment income. So investment income is another portion of the current account. And we earn investment income when we do invest in foreign nation stocks and bonds, for example. Any income that we would earn off of those would be in our current account. Finally, transfer payments. Just one example I came up with was when Americans donate money to, let's say, some kind of charity in another nation, maybe some relief effort after natural disaster.
OK, so a trade surplus and deficit really comes up in to play here. So this is one of your key terms. A trade surplus occurs when our exports exceed our imports. So when that term, our net exports, is positive. And a trade deficit occurs when our imports are greater than our exports. And so the net exports would be negative.
In the current account-- I already mentioned this before, but let's look at it in a slightly different way. And so the exports are going to credit this account and create a surplus. So a surplus in the current account is going to cause our currency, or that nation's currency, to appreciate over time. And that's because whenever this is going on, that nation's currency is being demanded in order to purchase these things measured in the current account.
So for example, when I was talking about, let's say, when Europeans were vacationing here in Disney World, they were demanding US dollars and supplying their euros. So our nation's currency, the US dollar, would be appreciating over time if this were the case. But when we import things, that can create a deficit. And the deficits will cause a nation's currency to tend to depreciate over time. So when we're supplying a whole lot of our US dollars in order to get other nation's currencies, then ours will tend to lose value or depreciate against the other currencies.
So every transaction that's going on in the current account is actually offset by an equal and opposite activity that's going on in the capital account. So let's talk about the capital account. This is capturing investment and financing flows. So here, whereas in the current account exports were what would have an appreciating impact on our currency, now it's inflows in the capital account that are going to have an appreciating impact on a currency. Outflows would have the opposite or depreciating impact.
So this is comparing a nation's ownership of foreign assets with foreign ownership of that nation's assets. So for example, the purchase or construction of machinery, buildings, or plants in other nations or the investment in a foreign nation's shares and bonds is also an example. So when foreigners are investing in those kinds of things in our country, that's an inflow into the capital account, and that creates a surplus. But our citizens investing in those things in foreign nations are an outflow or create a deficit in the capital account.
Remember these are opposite from things going on in the current account. So because of that, because these two things are offsetting and are opposite, these two accounts would sum to zero. So I just came up with one example. If I decide to buy a German car, what kind of impact does that have?
Well first of all, if I buy a German car, that means that US imports are increased by that car. So that's the impact in the current account. But foreign assets in the United States are also increased. That's going on in the capital account. So I had to supply my dollars in order to purchase the car in euros. So I'm demanding euros, and therefore, the foreign ownership there in the US is increased.
What's the net result? The net result is that the net wealth position of our country compared to the rest of the world would decrease by the price of the car. So obviously with just one person's purchase of a car, it's not going to have a huge impact, but you can see that over time being a net-exporting or net-importing nation can have a big impact on the nation's currency and on these accounts.
So in this tutorial, we talked about the balance of payments and how it's comprised of the current and the capital account. You looked at how that current and capital account have equal and opposite transactions in each one, so they would sum to zero. We talked about trade surpluses and deficits and the impact that they have on our balance of payments. Thanks so much for listening. Have a great day.
Terms to Know
Balance of Payments
A record of all monetary transactions that flow across a country’s border; two major components are the current account and the capital account.
Represents the sum of all recorded transactions including traded goods, services, income, and net transfer payments.
Captures investment and financing flows; inflows have an appreciating impact on a given currency; outflows have the opposite, or depreciating, impact.
Trade surplus occurs when exports exceed imports (X – M > 0) and a trade deficit occurs when imports exceed exports (X – M < 0).