[MUSIC] Before can start to explore the meaning of the balance of payments, we've got to look at it's different components, define the kind of transactions we put there and where they go, and their meaning. So just to start out, the balance of payments is a record of all of the economic transactions between one country and the rest of the world, okay? And includes all sorts of transactions. And what we need to remember about balance of payments are two things. One is that we enter items as a credit or a debit. So if it's a credit that means that it gives rise to a flow of money into the country. So, for example, I buy a product from Japan, for me that purchase which is an import is a debit because a flow of money goes to Japan. But for Japan, it's a credit because a flow of money goes into Japan. So, whether an item is a credit or a debit is determine by the direction of flow of money. Secondly, we enter each item twice, okay? It's what we call double entry book keeping, which some of you may be familiar with. So because every item goes in twice, it goes in one side of the balance payments, and then on the other side, the two sides have to balance, by definition. Now they don't always, as we'll see, because this is really complex. A country's economic transactions with the rest of the world are billions of dollars and there are things that we miss, right? And the different items are entered separately. So sometimes the two sides don't balance and we'll see what we do about that. But anyway, by definition, the two sides of the balance of payments must balance. Now, the two sides of the balance of payments are the current account and the financial account. Under the current account, which is what we're going to focus on the most in this section, talking about the current account and its meanings. Under the current account, there are three sections. The first one is the one we're most familiar with and that's the trade account, okay? Here we're thinking about exports and imports of goods and services between one nation and the rest of the world. So, here we'll put merchandise trade, which is the trade we're most used to talking about, automobiles, wheat, steel, whatever it is that we're trading importing and exporting with the rest of the world. This is merchandise trade. But there's also services, trade in services which is a huge part of global trade. And here we might have business services, we might have banking services, we might have tourism. All of those are part of trade. So we have the trade account, and countries may have a deficit, they may have a surplus, but the account may be balanced. The second part of the current account is the primary account. This includes income from the factors of production. So here we might have, the most important part is a country has investments in the rest of the world, okay? The rest of the world has investments in that country. So we think of these two big stocks of investment. What I have bought in the rest of the world, what the rest of the world has bought in me. Now every year those investments will give rise to some returns or some income, a flow of income. So the investments that I, as this country, have in the rest of the world, every year I'll bring home some income from them, okay? At the same time, every year the rest of the world will bring home some income from its investments in me. Now the difference between those two income flows is what we enter in primary income. It could be positive, it could be negative, it could be zero, okay? So we have trade, then we have the primary income account and then the last account that we have on the current account is the secondary account. Now this one is what we call transfers, these are one way transactions. So, for example, if my country gives aid to another country, it's not a transaction that then gives rise to some service being sent to me by that country, for example. I give aid and it's done. So that would be on the secondary account. Another really important item that's on the secondary account is remittances. If immigrants go, or migrants, as we're going to call them, go to live in another country, okay? They will send gifts home to their family. They will send of their income home to their family in the home country to live off of. These are called remittances and they enter into the balance of payment. So, for example, if someone from El Salvador is living in New York and they send some of there income home to their family, that would be in the secondary account for the United States and for El Salvador. For the United States, it would be a negative item because the money is flowing out, for El Salvador, it would be a positive item because money is flowing in. So, that's the current account, trade, primary income, secondary income. Now on the other side of the balance of payments we think of it as sort of a T with current account over here. On the other side we have the financial account. [COUGH] And like I said, every item is entered twice, so it will go into the current account, it will also go into the financial account. On the financial account, we have financial transactions, okay? The first one is net direct investment. So in any given year, foreigners will buy assets in a country. And when we put them into direct investment, they are long-term investments. So, for example, foreigners by land or they buy an entire company or they build a factory. That would be direct investment. Now, we're netting this out. So we will see the flows of foreign money into a country, and then the flows of that country's money into foreign countries in direct investments. The second part is portfolio investment. And portfolio investment is short-term investment. Direct investment is long-term, I'm buying land, I'm buying a factory, I'm going to be there for a while. Portfolio investment is what we sometimes think of as, hot money, this is short-term investments. So I buy some shares on the stock market, totaling less than 10% of the shares in the company. Or I buy a short-term bond, this is short-term money, hot money that can quickly leave, can quickly come back, okay? So, on the financial side, we've got net direct investment. We've got net portfolio investment. We also have bank and non-bank claims and liabilities, so these are loans, right? And then we have something called official settlements. This is where a country uses the reserves that it holds. And it either uses them to help pay for the imbalance between the current account and the financial side. Or it uses them to accumulate some of the extra money earned on the current account side. So that's there. And then we have an item that we call errors and omissions. Since the two sides don't always balance, as I said a little bit earlier. And if you have a look at a current account and a financial account, you'll see the two don't automatically add up to zero. We put in an item to make them equal, okay? We put this item on the financial side, because that's where the errors and the omissions often happen. So when you're reading a balance of payments, when you're reading a current account and a financial account, you'll see if they don't balance we just make them equal by putting in errors and omissions. [MUSIC]
