Balance of Payments

Financial or (Capital) Account Balance

Composed of direct investments, financial asset investments, bank assets liabilities, and a statistical discrepancy.

The statistical discrepancy is typically small in amount and serves as a plug value to tie the identity to 0 (zero).

Reserve Account Balance

Consists mostly of a government’s foreign currency holdings, but could also include inter-governmental exchange of gold.

If the value on the reserve account balance is positive, then a government has sold official reserve assets to buy back domestic currency.

Using Monetary Policy

A country’s central bank may ease monetary policy by increasing the money supply, with the objective of stimulating the economy.  The theoretical sequence of events is:

• Monetary stimulus (increasing the supply of money) causes real interest rates to drop;
• Foreign demand for domestic financial assets decreases because returns are now lower;
• The financial account balance declines because the inflow of foreign investment has dropped;
• The domestic currency then depreciates;
• The currency depreciation reduces imports (which have become more expensive) and increases exports (which are now cheaper to the rest of the world);
• The increase in exports reverses the deficit trend in the current account balance, as the growth in exports stimulates the country’s economy.

Using Fiscal Policy

A government may also use fiscal policy (taxing and spending) to stimulate the economy and this also has implications for interest rates, the balance of payments and the domestic currency valuation.

• Fiscal stimulus causes interest rates to rise, as lower tax revenues or higher government spending has increased the demand for borrowing by the government;
• Rising real interest rates attracts foreign capital, which increases the financial account balance;
• The inflow of foreign capital increases the value of the domestic currency;
• The decrease in the current account balance is matched by an increase in the financial account balance, as foreign investors have increased their holdings of the domestic currency.