To begin our study of International Trade, let's learn some basic balance of payments accounting. We can start by distinguishing between the so-called current account and the capital account. And then illustrate the critical relationship between the two. This relationship is summarized in the so-called Trade Identity Equation. It says that, "If a country runs a trade deficit in its current account, it must balance that deficit with equal inflows into its capital account." Conversely, "If a country runs a trade surplus in its current account, it must balance that surplus with an equal deficit in its capital account." And therefore, capital outflows. This is illustrated in this table, which presents the balance of payments schedule in a typical year, for a fictional country, we shall call Representative Nation. From the table, we can see that the current account consists of four items. The Merchandise Trade Balance, Fees for Services, Net Investment Income and Unilateral or Current Transfers. The Merchandise Trade Balance is by far the biggest item in the Current Account. It is also referred to as the trade in goods and it reflects trade in commodities such as food and fuels as well as trade in manufactured goods like shoes, and computers, and refrigerators. In the table, we see that Representative Nation shows accounting debits or imports of $803 billion. At the same time, Representative Nation's credits or exports are $612 billion. So what do you think? Is this country running a trade deficit in goods or a trade surplus? And would such a deficit or surplus, subtract from or add to its GDP growth? Well, let's remember here that imports are what a nation buys from other countries while exports are what that nation sells to the world. So in this case, Representative Nation is clearly running a net merchandise trade deficit of minus $191 billion. The imports of $803 billion minus the exports of $612 billion. And, because net exports are negative in our GDP growth equation, this trade deficits in goods will subtract from the nation's growth. Now here's the key point, when you read in the newspaper, that a country like Germany or Japan is running a trade deficit or a trade surplus, it is this merchandise trade balance to which journalists often are referring to. But, this is only part of the total current account and deficit picture. The second item in the current account is Fees for Services. Such services include such things as shipping, financial services and foreign travel. Note that while this fees for services categories generally much smaller than the merchandise trade balance for most nations, it can be an important component for a service-orientated economy. At least in this example, the service fees received by Representative Nation are $237 billion. The fees paid out are $157 billion. This yields a net surplus of $80 billion. And this will help this country at least partially offset what is a rather large merchandise trade deficit. The third item in the current account is Investment Income. And in our table, we see two important entries. The first is a credit of $206 billion. It's the amount of income earned and received by the citizens of Representative Nation holding foreign assets. The second entry is a debit of $203 billion and it's the amount of income earned by foreigners holding some investment assets of Representative Nation. The key point here, is that this investment income component of the current account can be an important component if for example, one nation gets heavily into debt to others. In such a case, income earned by foreigners will exacerbate the total trade deficit. This fourth and last category, Unilateral Transfers is a very minor one. It represents transfers from one country to another where nothing is actually received in return. For example, a natural disaster like an earthquake or a flood might happen in one country might receive donations or some other kind of official assistance from other countries. The same time, when immigrants to a country send money back to relatives or friends in the former country of residence, this too represents a unilateral transfer. In the table, we see that the Unilateral for transfers of minus $40 billion represent a small increase in the total trade deficit. So summing up the categories of the current account for the balance of payments in this example, we arrive at a balance on the current account of minus $148 billion. So here is a question for you, If the current account has a balance of minus $148 billion, what must be the balance in the capital account? And here's a hint. Do you remember, The Basic Trade Identity Equation we discussed earlier? Take a minute to figure this out. Write down your answer, when you're ready, let's move on to the next module.
