CHAPTER SUMMARY

1. The balance of payments accounts consist of the cur­rent account and the financial account. The current account records trade in currently produced goods and services, income from abroad, and transfers between countries.

2. The current account balance, CA, equals the sum of net exports of goods and services, net income from abroad, and net unilateral transfers. Ignoring net income from abroad and net unilateral transfers, the current account balance is the same as net exports, NX. The financial account balance, FA, is the value of assets sold to foreigners (financial inflows) minus the value of assets purchased from foreigners (financial outflows) plus net unilateral transfers of assets.

3. In each period, except for measurement errors, the current account balance, CA, and the financial account balance, FA, must sum to zero. The reason is that any international transaction amounts to a swap of goods, services, or assets between countries; the two sides of the swap always have offsetting effects on the sum of the current account and financial account balances.

4. In an open economy, goods market equilibrium requires that the desired amount of national saving equal the desired amount of domestic investment plus the amount the country lends abroad. Equivalently, net exports must equal the country's output (gross domestic product) less desired total spending by domestic residents (absorption).

5. A small open economy faces a fixed real interest rate in the international capital market. In goods market equilibrium in a small open economy, national saving and investment equal their desired levels at the pre­vailing world real interest rate; foreign lending, net exports, and the current account balance all equal the excess of national saving over investment. Any factor that increases desired national saving or reduces desired investment at the world real interest rate will increase the small open economy's foreign lending (equivalently, its current account balance).

6. The levels of saving and investment of a large open economy affect the world real interest rate. In a model of two large open economies, the equilibrium real interest rate in the international capital market is the rate at which desired international lending by one country equals desired international borrowing by the other country. Equivalently, it is the rate at which the lending country's current account surplus equals the borrowing country's current account deficit. Any factor that increases desired national saving or reduces desired investment at the initial interest rate for either large country will increase the supply of international loans relative to the demand and cause the world real interest rate to fall.

7. According to the twin-deficits hypothesis, the large U.S. government budget deficits of the 1980s and the first half of the 1990s helped cause the sharply increased U.S. current account deficits of that period. Whether budget deficits cause current account defi­cits is the subject of disagreement. In theory, and if we assume no change in the tax treatment of invest­ment, an increase in the government budget deficit will raise the current account deficit only if it reduces national saving. Economists generally agree that an increase in the budget deficit caused by a temporary increase in government purchases will reduce national saving, but whether an increase in the budget deficit caused by a tax cut reduces national saving remains controversial.

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