160 FAQ

The current account is like a 'national checking account.' It has four main components: trade in goods, trade in services, dividends (interest), and foreign aid and remittances. Dividends (interest paid by us to foreigners and also interest paid by foreigners to us) is a rather small amount; remittances and foreign aid can be rather important for some smaller, less-developed states. The first two elements, trade in goods and trade in services, are by far the largest components. Think of exports as 'credits' on the national current account (+), since they're money paid to us by another state, and imports as a 'debit' (-) since we pay some other state for those goods. So, the current account looks something like:

(exports of goods - imports of goods)
+(exports of services - imports of services)
+(dividends paid to us - dividends we pay to others)
+(net of remittances and/or foreign aid)
current account balance

If the current account balance is positive - in other words, we have more funds flowing into the country than out of it in a given year - we have a current account surplus. If the current account balance is negative - in other words, more money is flowing out of the country than into it in a given year - we have a current account deficit.

The capital account consists of investment coming into and out of a country. (Note: This is the value of the investment itself, not the returns on the investment. Those are in the 'dividends' category of the current account since they're paid regularly, whereas the investment itself is a one-time thing.) This includes both portfolio investment (stocks and bonds) as well as foreign direct investment (building factories, etc.) As with the capital account, if the net balance is positive the capital account has a surplus and if the net balance is negative the capital account has a deficit.

The reason it's called the 'balance of payments' is that the capital and current accounts must balance. A surplus in one must be offset by a deficit in the other. Why? Because my currency isn't of any use to anyone outside my country. If I'm sending a lot of goods and services abroad (i.e., have a current account surplus), I've got a lot of foreign currency that others have paid me for my goods, and since I can't use it, I invest it elsewhere. A state like the US can only finance its enormous current account deficit by attracting investment to cover the gap between its hard currency coming in from exports and its hard currency going out from exports and investment abroad.

A state usually preserves a bit of any hard currency coming into a country beyond what is needed to balance the accounts and puts it into the central bank's reserves. The reserves are a sort of a rainy-day fund which can be used to cover short-term shortfalls in the balance of payments. This isn't sustainable in the long run - a persistent negative balance will eat away at the rainy-day fund until it's gone - but it can cover for a few months if a short slump occurs. The reserves can also be used to make small interventions in international currency markets in defense of one's currency. For states with a fixed exchange rate, that pool of reserves directly governs (through some proportional formula) how much of its own currency it can issue. As the gap between the surplus and the deficit sides of the balance of payments grows, the reserves increase as well, and the state can issue more currency. In this way, the promotion of exports (or alternatively, the attracting of investment) allows the state to expand its money supply over time and grow its economy.