# Understanding balance of payments

Suppose US records exports (increase) in the current account. What would the corresponding decrease in the capital/financial account have to be? Why does there have to be a corresponding decrease in the first place? Why can't the exporter earning revenue use that solely for domestic purposes? In other words, why must a balance of payments happen in the first place. Must there be a balance of payments for every transaction? If so, how in the example here?

New to economics and trying to get some intuition

First, we should understand what the balance of payments is:

1. Current Account: This account records the trade of goods and services, income receipts (such as interest and dividends), and current transfers (such as foreign aid). An increase in exports would result in a surplus in the current account because it reflects an inflow of foreign currency.

2. Capital/Financial Account: This account records all international financial transactions. These include investments in foreign assets and liabilities (such as foreign direct investment, portfolio investment, and other investments).

Now let us consider why there should be a decrease: When there is an increase in exports, it means that foreign buyers are purchasing more goods from the US. They pay for these goods in foreign currency, which the US exporters then convert into US dollars. This inflow of foreign currency into the US must be balanced by an outflow in the capital/financial account. Here's why:

1. Accounting Identity: By definition, the sum of the current account and the capital/financial account must be zero. This is an accounting identity in the balance of payments: $$\text { Current Account }+ \text { Capital/Financial Account }=0$$

If there's a surplus in the current account (more exports), there must be a corresponding deficit in the capital/financial account (more imports of capital).

1. Currency Flows: When foreign buyers pay US exporters, they provide foreign currency. The exporters convert this foreign currency into US dollars. The converted dollars either:
• Stay in the foreign exchange reserves.
• Are used by US investors to purchase foreign assets (leading to an outflow in the capital account).
• Are lent to foreign borrowers (another form of capital outflow).

Even if the exporter decides to use the revenue domestically, such as saving it in a US bank or spending it within the US, the transaction still impacts the balance of payments. If the exporter deposits the money in a US bank, the bank might use these funds to invest abroad or lend to foreign entities, resulting in an outflow in the capital account. Additionally, if the exporter invests in domestic projects, these investments may lead to the import of capital goods, which also affects the current and financial accounts. Thus, the revenue generated from exports, even when used domestically, creates corresponding entries in the balance of payments to maintain equilibrium. The following example might demonstrate this well:

Suppose a US company exports machinery worth $$\\\ 1$$ million to a foreign company:

• Current Account: The $$\\\ 1$$ million sale is recorded as an export, resulting in a $$\\\ 1$$ million credit in the current account.
• Capital/Financial Account: The foreign company pays in its currency, which is converted to US dollars. The US exporter may use these dollars to:
• Invest in foreign bonds (resulting in a $$\\\ 1$$ million debit in the capital account).
• Keep the money in a US bank, which might then invest or lend the money abroad, leading to a capital account debit.

Thus, every transaction in the current account has a mirror transaction in the capital/financial account, ensuring that the balance of payments always balances.