Chapter 17: Macroeconomics and Trade Finance
17.5 Reasons for a Zero Balance
Equilibrium in the market for a country’s currency implies that the balance of payments is equal to zero.
Capital Flows
Trade within a country differs in one important way from trade between countries: unless the two nations share a common currency, any trade requires that countries to go through the foreign exchange market to trade currency, in addition to trading goods and services. For example, imagine that buyers in France purchase oranges produced in Chile. The French buyers use the euro to make the purchase, but the Chilean orange producers must be paid with the Chilean peso. This exchange between France and Chile requires that the firms exchange euros for pesos.
In general, there are two reasons for demanding a country’s currency: to purchase assets within the country and to purchase a country’s exports – that is, the goods and services produced within that country. The country’s currency is supplied when it is used to purchase foreign currencies. This also happens for two reasons: to purchase assets in other countries and to import goods or services from other countries.
Imagine that we are analyzing Italy’s economy and its currency transactions with the rest of the world. If an American buyer wishes to purchase bonds issued by an Italian corporation, she becomes part of the world demand for euros to buy Italian assets. Adding the demand for exports to the demand for assets outside of a country, we get the total demand for a country’s currency.
Likewise, a country’s currency is supplied when it is used to purchase currencies in the rest of the world. Italian euros, for example, are supplied when Italian consumers or firms import goods and services from the rest of the world. Italian euros are also supplied when Italian purchasers acquire assets from other countries.
Equilibrium and Zero Balance
When a country’s balance of payments is equal to zero, there is equilibrium in the market for that country’s currency. Equilibrium occurs when:
[latex]\text{quantity of currency demanded} = \text{quantity of currency supplied}[/latex]
We have already seen that the quantity of currency demanded is equal to the demand for exports and demand for domestic assets. The quantity of currency supplied is equal to the demand for imports and the domestic demand for foreign assets. Thus, we can rewrite the relationship:
[latex] \text{exports} + \text{(foreign purchases of domestic assets)} =[/latex]
[latex]\text{imports} + \text{(domestic purchases of foreign assets)}[/latex]
Finally, we can rearrange the above formula as:
[latex]\text{exports} - \text{imports} =[/latex]
[latex]\text{(domestic purchases of foreign assets)} - \text{(foreign purchases of domestic assets)}[/latex]
The left-hand term is net exports – the difference between the amount of goods and services a country exports and the amount that it imports. We refer to this difference as the current account. When a country exports more goods than it imports, this number is positive, and we say that the country has a current account surplus. When a country imports more than it exports this number is negative and we say that the country has a current accounts deficit.
The right-hand term is the difference between the foreign assets that people within the country purchase and the domestic assets that are purchased by foreigners. This is called the financial account. These assets include the reserve account (the foreign exchange market operations of a nation’s central bank), along with loans and investments between the country and the rest of world (but not the future regular repayments/dividends that the loans and investments yield; those are earnings and will be recorded in the current account). The financial account is also sometimes used in a narrower sense that excludes the foreign exchange operation of the central bank. When a country buys more foreign assets that other countries buy of its assets, this balance is positive and there is a financial account surplus.
If the above equation holds true, then any current account surplus must be matched by a financial account deficit, and vice versa. This holds true when a country’s currency market is in equilibrium and there are no external currency controls.
Did You Know? Canada’s Balance of Payment
Let’s look at the balance of payment accounts in Canada. Table 17.1 shows the actual Canadian balance of payments accounts from 2016.
| Current Account | Receipts (Exports) | Payments (Imports) | Balance |
|---|---|---|---|
| Goods | 521.4 | 547.2 | −25.8 |
| Services | 107.2 | 129.3 | −22.1 |
| Investment Income | 91.5 | 106.3 | −14.8 |
| Transfers, etc. | 13.6 | 18.6 | −5 |
| Balance | n/a | n/a | −67.7 |
| Financial Account | Foreign in Canada | Canada in Foreign | Balance |
|---|---|---|---|
| Direct Investment | 41.8 | 85.1 | −43.3 |
| Portfolio Investment | 161.3 | 13.8 | 147.5 |
| Other investment | 59.3 | 91 | −31.7 |
| Balance | n/a | n/a | 72.5 |
| Balance of Payments | Amount |
|---|---|
| 1. Current Account Balance | − 67.7 |
| 2. Financial Account Balance | 72.5 |
| 3. Statistical Discrepancy | 2.7 |
| 4. Official Reserves | 7.4 |
| Balance of Payments (1+2+3–4) | 0 |
Source: Statistics Canada, CANSIM Tables 376-0101, 376-0102. Credit: Reused from “12.1: The balance of payments,” by Curtis and Irvine, under a CC BY-NC-SA license.
In Table 17.1, the payments by foreigners buying Canadian assets exceeded the payments made by Canadians buying foreign physical and financial assets. A financial account surplus was the result. The change in official international reserves records the increase or decrease in the Government of Canada’s holdings of foreign currency balances. Because Canada maintains a flexible exchange rate, annual changes in international reserves are small. Finally, the balance is shown as the sum of accounts (1 + 2 + 3 – 4), namely [latex](-67.2+72.5+2.7-7.4)[/latex] nearly equals [latex]0[/latex].
Canada’s Balance of Payment in Historical Context
Table 17.2 shows Canada’s trade picture in 2020 compared with some other economies from around the world. While the Canadian economy has shown a mixed trend of trade balance in recent years, Japan, and many European nations, such as Germany, have consistently run trade surpluses. Some of the other countries listed include Brazil, the largest economy in Latin America; Nigeria, along with South Africa competing to be the largest economy in Africa; and China, India, and Korea.
The first column offers one measure of an economy’s globalization: exports of goods and services as a percentage of GDP. The second column shows the trade balance as a percent of GDP. Usually, most countries have trade surpluses or deficits that are less than 5% of GDP. As you can see, Canada’s current account balance is −1.8%, U.S. current account balance is −2.9% of GDP, while Germany’s is 7.0% of GDP.
| Countries | Exports of Goods and Services | Current Account Balance |
|---|---|---|
| United States | 10.2% | –2.9% |
| Japan | 15.5% | 3.2% |
| Germany | 43.4% | 7.0% |
| United Kingdom | 27.9% | –2.6% |
| Canada | 29.0% | –1.8% |
| Sweden | 44.6% | 5.7% |
| Korea | 36.4% | 4.6% |
| Mexico | 40.2% | 2.4% |
| Brazil | 16.9% | –1.8% |
| China | 18.5% | 1.9% |
| India | 18.7% | 1.2% |
| Nigeria | 8.8% | –3.9% |
| World | – | 0.0% |
To gain a more complete picture Canada’s balance of trade, visit the website to explore Canada’s trade balance over past two decades. Try looking at different time ranges and their graphics.
Attributions
“17.5 Reasons for a Zero Balance” is adapted from “Open Economy Macroeconomics: Capital Flows” by “Boundless Economics,” licensed under CC BY-NC-SA, except where otherwise noted, and shared on Course Sidekick.
“Table 17.1: The Canadian Balance of Payments, 2016 (Billions of Canadian $)” is reused from Table 12.1 in “12.1: The balance of payments,” in Principles of Macroeconomics, which is shared under a CC BY-NC-SA license and was authored, remixed, and/or curated by Douglas Curtis and Ian Irvine (Lyryx).
“Canada’s Balance of Payment in Historical Context” is adapted from “10.2 Trade Balances in Historical and International Context” in Principles of Macroeconomics 3e, by Shapiro, MacDonald & Greenlaw. Copyright Rice University, OpenStax, used under CC-BY 4.0 license. Access “Principles of Macroeconomics” for free.
the market in which people or firms use one currency to purchase another currency
the change in the Government of Canada's foreign currency balances.
