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Intuition behind why the current account and capital account should balance
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Let's see if we can give ourselves an intuitive understanding of why the current account balance and the capital account balance nets out and over here, I have simplified versions of the current account.
And the capital account for the u.s in 2007.
we'll just go line by line and think about what this is saying.
And just also think about big picture in terms of the actual transfer of u.s dollars.
So first right over here on the current account, we see that we have a balance of trade, or we have a trade deficit right over here.
The u.s is importing much more than it is exporting.
And so off a net basis, you're importing a bunch of stuff.
You have to pay the foreigners for the stuff you imported.
And so you have an outflow of funds and this dominates, the current account right here.
It's the it's, the great majority of the current account balance.
This right over here.
This 95.7 billion this tells us that in that year in 2007, you americans got 95.6 billion more in income from assets that they owned abroad.
Then foreigners got an income that they had from u.s assets.
So this was an inflow of funds from that a net inflow from that income.
But then the us gave away more than that to the rest of the world.
This could be foreign aid from the u.s government, or it could just be american citizens sending payments to their family members in other parts of the country, or also doing some type of a donation for some type of aid program or whatever else.
But we see that the balance of trade is really what's dominating.
So one kind of if you really were to look at the current account into very rough terms, especially if you were to focus on the balance of trade, we see what's happening is what's coming to the u.s.
And so let me write over here.
This is the u.s and right over here.
Let me write rest rest of rest of world.
So the u.s for the most part, the story that this is telling us is that the us is getting the us is getting a bunch of stuff and then it's get it's paying for that stuff.
And then also giving away a little bit more than that.
And so what the rest of the world is getting the rest of the world is getting is 700 is net, 710.8 billion in u.s currency so 710.8 billion times.
So in u.s currency, but we know that that's not the entire picture.
We also have the change in ownership of assets.
And so what I'm going to do is I'm just going to func I'm just going to focus on the top two lines of the capital count right over here, which focuses on change foreign purchases of u.s assets and u.s purchases of foreign assets.
And oftentimes when people talk about the capital count they're, really just talking about these two lines, although the technically the capital count is all three of these lines and the way some people differentiate it.
This is kind of the narrow definition of the capital account.
And then the broader definition of the capital account would be all three of these lines, but let's just focus on these two lines right over here, the foreign purchases of u.s assets and the u.s purchases of foreign assets.
So we see that the foreigners are buying many more u.s assets than americans are buying abroad, but we could actually net it out and let's get our calculator to do it.
So if we net it out so foreigners are buying 2 trillion worth of u.s assets.
So that's an inflow.
They have to pay us dollars to buy our real estate and our stocks and whatever else.
But then you americans are going out there and they're using those dollars and they're converting it to foreign currency and they're buying other foreigners assets as well to a true to tune of about 1.3 trillion.
So that's, an outflow so let's subtract that out one two, eight, nine point, five.
So if we just net out these two these first two lines, we have 768.2 billion.
So one way you could view this if you were to net this out on a net basis, foreigners are buying 768.2 billion of u.s assets.
So let me write it this way.
So so let me so foreigners are getting u.s assets, u.s assets.
And in exchange americans americans are getting what was that 768.2 billion of currency.
Now this is an interesting thing.
Americans are shipping this currency abroad to buy mainly stuff, some of it's kind of a giveaway, but mainly to buy stuff 710.8 billion, but more than that is coming back for foreigners buying us assets.
And so it leads to an interesting question.
How is this possible? How is more coming in than going out? And the only way that this is possible that foreigners are able to ship more dollars to us than we're shipping to the rest of the world.
If this is, if the foreigners had a pile of currency to begin with.
So if they had a pile of currency to begin with so let's say that they have this in their central bank, so they have a pile of u.s dollar reserves, and I won't, well, maybe we'll have time to go into the details.
But you can imagine there's a pile of of of dollar dollar currency in the rest of the world.
And the only way that they're going to be able to ship us more dollars.
And we've shipped to them is this, if they dig into their reserves of u.s currency, and how much are they going to have to dig into the reserves what's just going to be the difference between this two let's, see how much they have to dig into it.
So we are sending this is how much they are.
This is how much they're shipping to us, we're shipping back to them, mainly because of the balance of trade, but in general, because of the current account deficit 710.8 billion.
And so that leaves there's 57.4 billion that's, not accounted for by what we're shipping to them.
So essentially they're going to have to dig into their reserves by 57.4 billion to make up the difference and that's.
What we have right over here.
The foreigners reserves are going to have to go down by 57.4 billion.
So let me write this.
This is net.
Let me make it clear.
This is we could view this as our net change net change in official and I'll write here, foreign foreign foreign reserves.
And in general, we view this as the central banks of other governments having to they had some piles of dollars around.
And for whatever reason they decided to use some of those dollars in foreign exchange markets, mainly probably because so their own people could go out and buy u.s assets or to buy u.s things or transfer money in some way to the u.s and also we'll go into more detail.
So it doesn't affect the exchange rates too much.
But this is essentially why these two things add up any any amount that these two things don't add up any amount by which the current account balance, and the narrow definition of the capital.
Count balance do not add up then that's going to have to be a change in reserves there's going to have to be in this case, more net.
More money, u.s dollars are being sent to the u.s.
So someone's pile of u.s dollars someplace in the rest of the world had to be depleted to the effect of 57.4 billion dollars in future videos.
We'll talk a lot more about about central banks, reserves of dollars and even interesting things about how george soros made a lot of money by kind of gaming that and all the rest.
While current accounts track the flow of imports and exports, capital accounts track the flow of assets and liabilities. The sum of current and capital accounts is always zero, meaning that when a country has a deficit in its current account, it necessarily has a surplus in its capital account and vice versa.What is the correlation between current and capital account? ›
The current and capital accounts represent two halves of a nation's balance of payments. The current account represents a country's net income over a period of time, while the capital account records the net change of assets and liabilities during a particular year.Why does the sum of the current account and financial account have to equal zero? ›
The Relationship Between the Accounts
The current account is always offset by the capital and financial account so that the sum of these accounts – the balance of payments – is zero.
The current account deals with exports and imports of a country. Capital account deals with the assets, capital transfer of the country. That means the capital account is all about finding the sources of capital and creating the right application for the current account and financial account.Why do current and available balances show different amounts of money in the same account? ›
The available balance for your account may differ from the current balance because of pending transactions that have been presented against the account, but have not yet been processed. Once processed, the transactions are reflected in the current balance and show in the account history.What causes capital account deficit? ›
A capital account deficit occurs when the equity in a business turns negative. This means that the total amount of liabilities exceeds the total amount of assets.What is the relationship between the current account and the capital account in the balance of payments quizlet? ›
The current account and the financial account are part of the balance of payments. If you sum up the balances of the current account, the financial account, and the capital account, you will arrive at a sum equal to the balance of payments.Why partners have separate capital and current account? ›
A partner's total capital is the sum of the balances on their capital account and their current account. In practice, however, it is convenient to separate the amount invested by the partner (the capital account) from the amount they have earned through the trading activities of the partnership (the current account).What is capital and current ratio? ›
The working capital ratio is calculated simply by dividing total current assets by total current liabilities. For that reason, it can also be called the current ratio. It is a measure of liquidity, meaning the business's ability to meet its payment obligations as they fall due.Why must the two sides of the accounting equation balance? ›
The bottom half (Liabilities + Equity) breaks down how this value was acquired, i.e. the sources of funding. The two halves must balance because the total value of the business's assets will all have been funded through liabilities and equity.
The balance of payments always balances. Goods, services, and resources traded internationally are paid for; thus every movement of products is offset by a balancing movement of money or some other financial asset.Why may a current account deficit just not matter? ›
A current account deficit indicates that a country is importing more than it is exporting. Emerging economies often run surpluses, and developed countries tend to run deficits. A current account deficit is not always detrimental to a nation's economy—external debt may be used to finance lucrative investments.What is the difference between the current account and the capital account quizlet? ›
1) The current account: measures the balance of trade in goods and services, flow of income between nations, and monetary gifts/grants that float in/out. 2) The capital account: measures the transfer of ownership of capital goods between nations.Is current account open if capital is? ›
Current accounts of the partners should be opened when the capitals are Fixed.What types of account is a capital account and why? ›
Capital account is the account of a natural person, i.e. an account of person who is alive. Hence, it can be classified as a personal account.What affects current account balance? ›
A nation's current account balance is influenced by numerous factors – its trade policies, exchange rate, competitiveness, forex reserves, inflation rate and others.Why is my current balance higher than my transactions? ›
The reason for the discrepancy is that your credit card statement balance is the amount you owed on the closing date of the last billing cycle. Your current balance includes any purchases and payments you've made in the current billing cycle.What determines current account balance? ›
How Is the Current Account Balance Calculated? The current account is calculated by finding the balance of trade and adding it to net earnings from broad and net transfer payments.What happens if capital account is negative? ›
So you need to transfer the profit to the capital account. If capital is negative after transferring profit/loss, then it is a situation of bankruptcy, and loss has to be displayed in the personal return.What increases and decreases capital account? ›
for a capital account, you credit to increase it and debit to decrease it.
Answer and Explanation:
But in reality, there could be difference between net capital flow and current account deficit, due to measurement errors, among other things. Such difference is called statistical discrepancy.
The balance of payments includes both the current account and capital account. The current account includes a nation's net trade in goods and services, its net earnings on cross-border investments, and its net transfer payments.What is the relation between current account deficit and current account balance? ›
A nation's current account balance may be either a deficit or a surplus, depending on whether its total receipts from other countries are less than or greater than its total payments to other countries. A current account deficit occurs when a country sends more money abroad than it receives from abroad.What are the current account and capital account transactions? ›
The current account tracks actual transactions, such as import and export goods. The capital account tracks the net balance of international investments – in other words, it keeps track of the flow of money between a nation and its foreign partners.What is the difference between fixed capital account and current account in partnership? ›
Capital account is related to the basic transactions related to the partners capital whereas the current account is related to all the other capital related transactions like interest on drawings, interest on capital, salary to employees apart from initial investment, addition of new capital and withdrawal of capital.What happens to a partner's capital account when they leave? ›
The leaving partner pays a bonus to the remaining partners by not taking the full amount of the his or her capital balance. Any remaining balance would be allocated between the remaining partners.What is the formula for current capital ratio? ›
How Is the Current Ratio Calculated? Calculating the current ratio is very straightforward: Simply divide the company's current assets by its current liabilities.How do you calculate net working capital? ›
- Example: A manufacturer has assets totaling $220,000 and liabilities totalling $130,000.
- Working capital = current assets - current liabilities.
- Net working capital = current assets (less cash) - current liabilities (less debt)
- Net working capital = accounts receivable + inventory - accounts payable.
Net working capital ratio shows how much of a company's current liability can be met with the company's current assets. The net working capital ratio is the measure of a company's capability in meeting the obligations that must be paid within the foreseeable future.Why are assets always equal to capital and liabilities? ›
Answer and Explanation: The assets of a business may be financed by two prominent sources of funds, namely, liabilities and shareholders' equity. Hence, we can say that the assets of a business are equal to the sum of liabilities and owner's equity.
Two basic accounting rules regulate increases and decreases of account balances: 1) Account balances increase on the normal balance side of an account. 2) Account balances decrease on the side opposite the normal balance side of an account.What are the two accounting rules? ›
The two basic accounting rules are 1) Account balances increase on the normal balance side of the account. 2)Account balances decrease on the opposite side of the normal balance side of the account.What is the most important part of the balance of payments? ›
What Is the Most Important Part of the BOP? The balance of trade (BOT), which is the combination of goods and services (aka the total of imports and exports), is the biggest part of the BOP. It makes it clear whether a country has a trade surplus or deficit.Why balance of payments is a problem? ›
The balance of payments can often cause problems for policy makers. A large deficit (or even surplus) may need policies developed to correct it - particularly in the medium to long term. To a large extent, the growth of imports and exports will depend on the levels of economic growth domestically and overseas.What is the problem of balance of payment? ›
The problem of balance of payment arises when there is rise in the balance of payment deficit. This problem can be managed when exports start rising and imports start reducing. Policies must be created which will help in stimulating exports.How do you fix current account deficit? ›
- Devaluation of exchange rate (make exports cheaper – imports more expensive)
- Reduce domestic consumption and spending on imports (e.g. tight fiscal policy/higher taxes)
- Supply side policies to improve the competitiveness of domestic industry and exports.
When all credits and debits are added up, the entire accounting system must balance: The current account balance plus the capital account balance must sum to zero. Hence, a current account (trade) deficit implies a capital account surplus.How might growth affect a current account balance? ›
A higher rate of economic growth will cause higher levels of consumer spending. Therefore, there will be a rise in import spending – which will tend to cause a deterioration in the current account. In this case, economic growth is causing inflationary pressures as the economy gets close to full capacity.What is the main difference between current account and capital account? ›
The current account reflects the total net income of a country within a year. The capital account reflects the net change in the ownership of national assets of a country within a year. The current account mainly focuses on the receipts and disbursements related to the cash and non-capital items.What is the relationship between current account and capital account? ›
The current and capital accounts represent two halves of a nation's balance of payments. The current account represents a country's net income over a period of time, while the capital account records the net change of assets and liabilities during a particular year.
The Relationship Between the Accounts
The current account is always offset by the capital and financial account so that the sum of these accounts – the balance of payments – is zero.
In current account, amount can be deposited and withdrawn at any time without giving any notice. It is also suitable for making payments to creditors by using cheques. Cheques received from customers can be deposited in this account for collection. In India, current account can be opened by depositing Rs.What is an example of a capital account? ›
Examples of capital accounts
For example, if someone named Susan opens a flower shop, invests their money into the company and applies for a bank loan to rent a space, they're the sole proprietor of that flower shop. Therefore, the flower shop's balance sheet capital account could read: "Susan, Capital Account."
Non-financing banks cannot open any current account. If a customer is not having any overdraft or cash credit but having credit facility of ₹5 crore and above but below ₹50 crore, only lending banks can open a current account.What is the purpose of capital account? ›
A capital account is used in accounting to record individual ownership rights of the owners of a company. The capital account is recorded on the balance sheet and is composed of the following items: Owner's capital contributions made when creating the company or following the creation, as required by the business.Is a capital account a debit or credit balance? ›
The balance on a liability or capital account is always a credit balance.What is the entry for capital account? ›
The amount invested in the business whether in the means of cash or kind by the proprietor or owner of the business is called capital. The capital account will be credited and the cash or assets brought in will be debited.What is current account balance capital and financial account balance? ›
The current account records the flow of goods and services in and out of a country (imports and exports). The capital account measures the capital transfers between U.S. residents and foreign residents. The financial account reflects increases or decreases in a country's ownership of international assets.
The main difference between current account and capital account is that the former records a country's short-term transactions related to trade and investment, while the latter records a country's long-term financial transactions.Why does capital show credit balance? ›
A capital account shows credit balance. It represents the amount owed by a business to the owner of the business. Thus, it is a liability for the business. All the liabilities represents the credit balance.
Capital = Assets – Liabilities
It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.
The capital account of the balance of payments is a record of all transactions which alter the external assets and/or liabilities of a country.Is the balance in the capital account on the credit side? ›
In the owner's capital account and in the stockholders' equity accounts, the balances are normally on the right side or credit side of the accounts. Therefore, the credit balances in the owner's capital account and in the retained earnings account will be increased with a credit entry.Is capital a debit or credit and why? ›
The balance in a capital account is usually a credit balance, though the amount of losses and draws can sometimes shift the balance into debit territory. It is usually only possible for the account to have a debit balance if an entity has received debt funding to offset the loss of capital.Is capital a debit or credit? ›
Capital is recorded on the credit side of an account. Any increase is also recorded on the credit side. Any decrease is recorded on the debit side of the respective capital account.How does a capital account balance work? ›
The capital account, on a national level, represents the balance of payments for a country. The capital account keeps track of the net change in a nation's assets and liabilities during a year. The capital account's balance will inform economists whether the country is a net importer or net exporter of capital.Why each partner has both a current and a capital account? ›
The Partner's Capital account shows the same balance from year to year unless additional amount is introduced or withdrawn. The Partner's Current account shows all items relating to the partners; like interest on capital and drawings, share of profit etc.