The balance of payments for a country summarizes all the international transactions that involve either an outflow or an inflow of money. It is composed of three major elements: (1) the current account, (2) the capital account, and (3) the official reserves transactions account. The official reserves transactions account reflects the official transactions between central banks that must occur when the combined balance of the current and capital accounts is in either the deficit or surplus column.
Transactions that lead to an outflow of money are registered as a debit in the balance of payments, and are entered with a negative sign. Transactions that lead to an inflow of money are registered as a credit, entered with a plus sign. Imports of foreign goods cause an outflow of money, entered with a negative sign in the balance of payments. Exports of domestic goods to foreign buyers lead to an inflow of money, registering as a credit with a plus sign. The balance of trade is total exports minus total imports.
A balance of trade deficit causes a net outflow of money, and a surplus causes a net inflow of money. Income earned from foreign investments and money transferred between citizens of different countries can also influence the balance of payments. When these types of flows are figured into the balance of trade, the outcome is the balance on current account.
Capital flows between countries show up in the balance of payments on the capital account. When domestic investors purchase financial or nonfinancial assets in foreign countries, capital flows out, and money also flows out, registering with a negative sign on the balance of payments. When U.S. citizens purchase stock on the Tokyo stock exchange, dollars flow out, just as when U.S. citizens purchase a Toyota. When foreign investors purchase financial or nonfinancial investments in the domestic economy, capital flows in, and money flows in, registering as a positive sign in the balance of payments. The sale of U.S. government bonds to Japanese investors causes dollars to flow into the United States. If a domestic seller exports goods abroad on credit, the sale of goods is entered as a plus sign in the balance of payments, and the grant of credit is a capital outflow and is entered with a negative sign.
Capital flows often offset imbalances in the balance of trade, as can be observed in the bilateral relationship between the United States and Japan. United States exports to Japan fall well short of U.S imports from Japan, contributing to a deficit on the balance of trade, and an outflow of dollars. In turn Japan invests significantly in the United States, building factories, and purchasing real estate and U.S. government bonds. Japan earns dollars by selling goods in the United States, and invests those dollars back in the United States, causing dollars to flow out on the current account, and flow in on the capital account.
If the outflow of money exceeds the inflow of money, the central banks must settle accounts by compensating adjustments in holdings of gold, foreign exchange, or other reserve assets. An excess of money outflow over money inflow will draw down the reserves of the domestic central bank, while an excess of money inflow over money outflow will build up reserves of the domestic central bank. An excess in the outflow of money leaves foreigners with a claim on domestic resources, and excess in the inflow of money has the opposite effect.
Persistent deficits or surpluses on the combined current and capital accounts cause changes in the value of domestic currency in foreign exchange markets. A deficit causes supplies of domestic currency to build up in foreign exchange markets, and the domestic currency will lose value. As the currency loses value, imports become more expensive, and exports become cheaper in foreign markets. Together these forces will remove the deficit. A surplus causes domestic currency to gain value in foreign exchange markets, making imports cheaper, and exports more expensive in foreign markets. These forces act to remove the surplus.
