Looking at the flow of money in and out of countries around the world

 Flow of money Money is constantly flowing around the world as people, businesses and government transact business with other countries. People travel, goods are imported and exported, investments are made….

  The balance of payments records the transactions between residents of a country and the residents of all other countries. Credits show money coming in to the country while debits show money leaving the country.  By definition, the sum of credits and debits always equals zero Balance of payments

  Obviously different countries have different currencies. If a Canadian travels to India, she must exchange her Canadian dollars for Indian rupees in the foreign exchange market. She demands Indian rupees and supplies Canadian dollars within the foreign exchange market. The foreign exchange market facilitates financial transactions among people, businesses and governments as they interact with other countries. Foreign Exchange

  When trading one currency for another, the demand for a particular foreign currency generates a supply of the domestic currency (and vice versa). So all money coming into India (credits) must originate with a demand for rupees, while all money leaving India (debits) must begin with a supply of rupees to buy a foreign currency. Supply and demand

  A country’s balance of payments is presented in chart or table form with three main categories. These categories are:  The current account  The capital account  The financial account Balance of payments

  The current account lists exports of a country (credit) as well as imports to the country (debit) for both goods and services. If a country’s exports of goods and services exceed their imports, then they will have a surplus on its balance on goods and services. Additionally, net income and net transfers are listed in the current account. A country like the USA has a negative current account balance (deficit) because its imports greatly exceed its exports. Current Account

  For a country like the USA with a deficit in its current account, more dollars are supplied in the foreign exchange market than dollars are demanded. So the sum of debits is larger than the sum of credits.  The trade balance is the largest of all the categories within the current account, so a country like China would have a surplus in its current account because it is a net exporter. Current Account

  The capital account shows the net flow of funds for the purchase of assets such as land or natural resources. This is not a large part of the balance of payment equation, and may be either positive or negative. Capital Account

  The financial account shows the net flow of funds into and out of the country in the form of assets, foreign investments and loans to or from other countries. A country like the USA has a positive balance in its financial account as it receives more funds from foreign countries in the form of investments and purchases of USA physical capital, than Americans invest abroad. Financial Account

  The USA has a surplus in its financial account meaning that credits exceed debits and the quantity of dollars demanded exceeds the quantity of dollars supplied. Therefore there is an excess of US dollars demanded in the foreign exchange market. Financial Account

  The moral of the story is that for every country the value of the current account will be offset by the value of the capital account plus the value of the financial account, which is why its called the balance of payments.  The quantity of domestic currency demanded will be equal to the quantity of domestic currency supplied for two reasons….. Balance of Payments

  Reason 1—A country’s central bank can buy and sell foreign currency to create a balance of payments  Reason 2—Changes in exchange rates can also create a balance of payments Balance of Payments

  If for some reason there isn’t exact equality between the current account and the combined capital account and financial account, an entry called statistical discrepancy will be listed to ensure that a balance of payments is arrived at.  This will create a situation where the credits and debits are equal to zero Statistical Discrepancies

  A country like the USA which is a net importer therefore has a deficit in its current account. It is enjoying a level of consumption beyond its PPC.  The USA must have a surplus in its financial account therefore to achieve its balance of payments, which may come from foreign investments in the USA or loans made to the USA by foreign countries. Another perspective

  A country like China which has a surplus in its current account balance because it is a net exporter is consuming beneath its PPC.  China, by selling so many exports, has a vast amount of foreign currency which it uses to buy foreign assets or to make loans to foreign countries. Therefore China has a negative financial account balance leading to its balance of payments. Yet another perspective