Components of the Balance of Payments Accounts: (Cambridge International A-Level Economics)

Components of the balance of payments accounts

• The balance of payments is a record of all financial transactions between a country and the rest of the world over a given time period - it must always balance as an accounting identity

• The balance of payments has three main accounts:

  • the current account,
  • the financial account and,
  • the capital account

The structure of the Balance of Payments

The current account

• The current account was covered in detail in the AS Section, Components of the Current Account

  • It records trade in goods, trade in services, primary income and secondary income
  • A current account deficit means debits exceed credits - the country is a net payer of funds to the rest of the world
  • A current account surplus means credits exceed debits - the country is a net receiver of funds

The financial account

• The financial account records flows of financial assets and liabilities between a country and the rest of the world - it finances imbalances on the current account
• It has four main components:

• A current account deficit must be financed by a surplus on the financial account - either through attracting foreign investment, borrowing abroad or running down reserve assets
• A current account surplus must be offset by a deficit on the financial account - the country is exporting capital, building up foreign asset holdings

The capital account

• The capital account is the smallest of the three accounts - it records non-financial, non-produced asset transfers and capital transfers between countries

  • Examples include: debt forgiveness between governments, transfer of assets by migrants moving country, purchases and sales of intellectual property rights (patents, trademarks)

• The capital account is typically very small relative to the current and financial accounts

How does the balance of payments balance?

The accounting identity

Current account + financial account + capital account = 0

• In practice, measurement errors mean a balancing item (errors and omissions) is included to ensure the accounts balance
• A current account deficit does not mean the overall balance of payments is in deficit - it means the financial and capital accounts must show a corresponding surplus to finance it

Worked Example Which components are included in the current account and financial account of the balance of payments?

	Current account	Financial account
A	Trade in goods	Official reserve assets
B	Primary income and secondary income	Trade in goods
C	Trade in goods and trade in services	Secondary income
D	Trade in services and secondary income	Portfolio investment and official reserve assets

Final answer: Answer: D

Option D is correct - trade in services and secondary income are both current account items; portfolio investment and official reserve assets are both financial account items

Worked solution

• Option A is incorrect - official reserve assets belong to the financial account, not the current account; trade in goods alone does not represent the full current account
• Option B is the trap - primary income and secondary income are correctly identified as current account components, but trade in goods is a current account component, not a financial account component; students who confuse the two accounts may select this
• Option C is incorrect - secondary income is a current account component, not a financial account component

Exam Hint The balance of payments always balances as an accounting identity - a current account deficit must be matched by a surplus on the financial and capital accounts combined.

A common error is confusing which components belong to which account:

• trade in goods and services, primary income and secondary income belong to the current account;
• FDI, portfolio investment and reserve assets belong to the financial account;
• capital transfers belong to the capital account.

In calculations, always identify the account before assigning credits or debits - money flowing in is a credit, money flowing out is a debit.