Countries are willing to trade with other countries because they can gain from the exchange. Without international trade, a country is restricted to consuming at a point on its production possibilities frontier, and not beyond. When a country produces a good for which it has a comparative advantage (a lower opportunity cost) and sells that good in exchange for a good for which it has a comparative disadvantage (higher opportunity cost), the country can consume a bundle of goods that lies beyond its production possibilities frontier. Therefore, international trade raises, or improves, the social welfare of a country. In 2012, people living in Canada sold about $810 billion worth of stuff to people living in other countries and bought about $810 billion worth of stuff in return. What kind of stuff? All kinds. Residents of Canada (including firms operating in Canada) sold airplanes, bonds, wheat, and many other items to residents of other countries. Residents of Canada bought cars, stocks, oil, and many other items from residents of other countries.

How can we keep track of these transactions? In Chapter 7 we learned that economists keep track of the domestic economy using the national income and product accounts. Economists keep track of international transactions using a different but related set of numbers, the balance of payments accounts.

A country’s balance of payments accounts are a summary of the country’s transactions with other countries.

To understand the basic idea behind the balance of payments accounts, let’s consider a small-scale example: not a country, but a family farm. Let’s say that we know the following about how last year went financially for the Lemieux family, who own a small apple farm in Nova Scotia:

How could we summarize the Lemieux’s year? One way would be with a table like Table 19-1, which shows sources of cash coming in and money going out, characterized under a few broad headings. The first row of Table 19-1 shows sales and purchases of goods and services: sales of apples; purchases of groceries, heating oil, that new car, and so on. The second row shows interest payments: the interest the Lemieux family received from their bank account and the interest they paid on their mortgage. The third row shows cash coming in from new borrowing versus money deposited in the bank.

In each row we show the net inflow of cash from that type of transaction. So the net in the first row is −$10 000, because the Lemieux family spent $10 000 more than they earned. The net in the second row is −$9500, the difference between the interest the Lemieux family received on their bank account and the interest they paid on the mortgage. The net in the third row is $19 500: the Lemieux family brought in $25 000 with their new loan but put only $5500 of that sum in the bank.

The last row shows the sum of cash coming in from all sources and the sum of all cash used. These sums are equal, by definition: every dollar has a source, and every dollar received gets used somewhere. (What if the Lemieux family hid money under the mattress? Then that would be counted as another “use” of cash.)

A country’s balance of payments accounts summarize its transactions with the world with a table basically similar to the way we just summarized the Lemieux’s financial year.

Table 19-2 shows a simplified version of the Canadian balance of payments accounts for 2012. Where the Lemieux family’s accounts show sources and uses of cash, the balance of payments accounts show payments from foreigners—in effect, sources of cash for Canada as a whole—and payments to foreigners.

Row 1 of Table 19-2 shows payments that arise from sales and purchases of goods and services. For example, the value of Canadian wheat exports and the fees foreigners pay to Canadian engineering companies appear in the second column; the value of Canadian electronic product imports and the fees Canadian companies pay to overseas call centres—the people who often answer your 1-800 calls—appear in the third column.

Row 2 shows factor income—the income countries pay for the use of factors of production owned by residents of other countries. Mostly this means investment income: interest paid on loans from overseas, the profits of foreign-owned corporations, and so on. For example, the profits earned by Bombardier Transportation Germany, which is owned by Canadian-based Bombardier Inc., appear in the second column; the profits earned by the Canadian operations of Japanese auto companies appear in the third column. This category also includes some labour income. For example, the wages of a Canadian engineer who works temporarily on a construction site in Dubai are counted in the second column.

Row 3 shows international transfers—funds sent by residents of one country to residents of another. The main element here is the remittances that immigrants send to their families in their country of origin.

Rows 4 and 5 of Table 19-2 show payments resulting from sales and purchases of assets, broken down by who is doing the buying and selling. Row 4 shows transactions that involve governments or government agencies, mainly central banks. Row 5 shows private sales and purchases of assets. For example, the 2012 purchase of Canadian oil firm Nexen Inc. by the Chinese state-owned firm China National Offshore Oil Corporation (CNOOC Ltd.) would show up in the second column of row 5; purchases of European stocks by Canadian investors show up in the third column.

In laying out Table 19-2, we have separated rows 1, 2, and 3 into one group and rows 4 and 5 into another. This reflects a fundamental difference in how these two groups of transactions affect the future.

When a Canadian resident sells a good such as wheat to a foreigner, that’s the end of the transaction. But a financial asset, such as a bond, is different. Remember, a bond is a promise to pay interest and principal in the future. So when a Canadian resident sells a bond to a foreigner, that sale creates a liability: the Canadian resident will have to pay interest and repay principal in the future. The balance of payments accounts distinguish between transactions that don’t create liabilities and those that do.

Transactions that don’t create liabilities are considered part of the balance of payments on current account, often referred to simply as the current account: the balance of payments on goods and services plus net international transfer payments and factor income. The balance of row 1 of Table 19-2, −$36.5 billion, corresponds to the most important part of the current account: the balance of payments on goods and services, the difference between the value of exports and the value of imports during a given period.

By the way, if you read news reports on the economy, you may well see references to another measure, the merchandise trade balance, sometimes referred to as the trade balance for short. This is the difference between a country’s exports and imports of goods alone—not including services. Economists sometimes focus on the merchandise trade balance, even though it’s an incomplete measure, because data on international trade in services aren’t as accurate as data on trade in physical goods, and they are also slower to arrive.

The current account, as we’ve just learned, consists of international transactions that don’t create liabilities. Transactions that involve the sale or purchase of assets, and therefore do create future liabilities, are considered part of the balance of payments on financial account, or the financial account for short. (Until a few years ago, economists often referred to the financial account as the capital account. We’ll use the modern term, but you may run across the older term.)

So how does it all add up? The shaded rows of Table 19-2 show the bottom lines: the overall Canadian current account and financial account for 2012. As you can see, in 2012 Canada ran a current account deficit: the amount it paid to foreigners for goods, services, factors, and transfers was more than the amount it received. Simultaneously, it ran a financial account surplus: the value of the assets it sold to foreigners was more than the value of the assets it bought from foreigners.

In the 2012 official data, the Canadian current account deficit and financial account surplus didn’t offset each other: the financial account surplus in 2012 was $3.4 billion smaller than the current account deficit. But that’s just a statistical error, reflecting the imperfection of official data. (That $3.4 billion discrepancy probably reflected foreign purchases of Canadian assets that official data somehow missed.) In fact, it’s a basic rule of balance of payments accounting that the current account and the financial account must sum to zero:

or

Why must Equation 19-1 be true? We already saw the fundamental explanation in Table 19-1, which showed the accounts of the Lemieux family: in total, the sources of cash must equal the uses of cash. The same applies to balance of payments accounts. Figure 19-1, a variant on the circular-flow diagram we have found useful in discussing domestic macroeconomics, may help you visualize how this adding up works. Instead of showing the flow of money within a national economy, Figure 19-1 shows the flow of money between national economies.

Money flows into Canada from the rest of the world as payment for Canadian exports of goods and services, as payment for the use of Canadian-owned factors of production, and as transfer payments. These flows (indicated by the lower green arrow) are the positive components of the Canadian current account. Money also flows into Canada from foreigners who purchase Canadian assets (as shown by the lower yellow arrow)—the positive component of the Canadian financial account.

At the same time, money flows from Canada to the rest of the world as payment for Canadian imports of goods and services, as payment for the use of foreign-owned factors of production, and as transfer payments. These flows, indicated by the upper green arrow, are the negative components of the Canadian current account. Money also flows from Canada to purchase foreign assets, as shown by the upper yellow arrow—the negative component of the Canadian financial account. As in all circular-flow diagrams, the flow into a box and the flow out of a box are equal. This means that the sum of the yellow and green arrows going into Canada is equal to the sum of the yellow and green arrows going out of Canada. That is,

Equation 19-2 can be rearranged as follows:

Equation 19-3 is equivalent to Equation 19-1: the current account plus the financial account—both equal to positive entries minus negative entries—is equal to zero.

But what determines the current account and the financial account?

A country’s financial account measures its net sales of assets to foreigners. There is, however, another way to think about the financial account: it’s a measure of capital inflows, of foreign savings that are available to finance domestic investment spending.

What determines these capital inflows?

Part of our explanation will have to wait for a little while because some international capital flows are carried out by governments and central banks, which sometimes act very differently from private investors. But we can gain insight into the motivations for capital flows that are the result of private decisions by using the loanable funds model we developed in Chapter 10. In using this model, we make two important simplifications:

Figure 19-2 recaps the loanable funds model for a closed economy. Equilibrium corresponds to point E, at an interest rate of 4%, where the supply of loanable funds curve, S, intersects the demand for loanable funds curve, D. But if international capital flows are possible, this diagram changes and E may no longer be the equilibrium. We can analyze the causes and effects of international capital flows using Figure 19-3, which places the loanable funds market diagrams for two countries side by side.

Figure 19-3 illustrates a world consisting of only two countries, Canada and Britain. Panel (a) shows the loanable funds market in Canada, where the equilibrium in the absence of international capital flows is at point E_Can with an interest rate of 6%. Panel (b) shows the loanable funds market in Britain, where the equilibrium in the absence of international capital flows is at point E_B with an interest rate of 2%.

Will the actual interest rate in Canada remain at 6% and that in Britain at 2%? Not if it is easy for British residents to make loans to Canadians. In that case, British lenders, attracted by high Canadian interest rates, will send some of their loanable funds to Canada. This capital inflow will increase the quantity of loanable funds supplied to Canadian borrowers, pushing the Canadian interest rate down. At the same time, it will reduce the quantity of loanable funds supplied to British borrowers, pushing the British interest rate up. So international capital flows will narrow the gap between Canadian and British interest rates.

Let’s further suppose that British lenders regard a loan to a Canadian as being just as good as a loan to one of their own compatriots, and Canadian borrowers regard a debt to a British lender as no more costly than a debt to a Canadian lender. In that case, the flow of funds from Britain to Canada will continue until the gap between their interest rates is eliminated. In other words, when residents of the two countries believe that a foreign asset is as good as a domestic one and that a foreign liability is as good as a domestic one, then international capital flows will equalize the interest rates in the two countries.

Figure 19-4 shows an international equilibrium in the loanable funds markets where the equilibrium interest rate is 4% in both Canada and Britain. At this interest rate, the quantity of loanable funds demanded by Canadian borrowers exceeds the quantity of loanable funds supplied by Canadian lenders. This gap is filled by “imported” funds—a capital inflow from Britain. At the same time, the quantity of loanable funds supplied by British lenders is greater than the quantity of loanable funds demanded by British borrowers. This excess is “exported” in the form of a capital outflow to Canada. And the two markets are in equilibrium at a common interest rate of 4%—at that interest rate, the total quantity of loans demanded by borrowers across the two markets is equal to the total quantity of loans supplied by lenders across the two markets.

Recall, in Chapter 10, we defined net foreign investment (NFI) as the net effect of international outflows and inflows of funds on total savings available for investment in any given. NFI is equal to the total outflows of domestic funds minus the total inflows of foreign funds. Why? As shown in Figure 19-4, at the international equilibrium interest rate of 4%, the domestic demand for funds in Canada (investment in Canada) exceeds the domestic supply of funds (national saving in Canada). Canada needs to borrow from Britain to make up the difference and Canada’s net foreign investment turns negative. The reverse holds true for Britain. In other words, net foreign investment = −net capital inflows.

In short, international flows of capital are like international flows of goods and services. Capital moves from places where it would be cheap in the absence of international capital flows to places where it would be expensive in the absence of such flows.

The open-economy version of the loanable funds model helps us understand international capital flows in terms of the supply and demand for funds. But what underlies differences across countries in the supply and demand for funds? Why, in the absence of international capital flows, would interest rates differ internationally, creating an incentive for international capital flows?

International differences in the demand for funds reflect underlying differences in investment opportunities. In particular, a country with a rapidly growing economy, other things equal, tends to offer more investment opportunities than a country with a slowly growing economy. So a rapidly growing economy typically—though not always—has a higher demand for capital and offers higher returns to investors than a slowly growing economy. As a result, capital tends to flow from slowly growing to rapidly growing economies.

The classic example, described in the upcoming Economics in Action, is the flow of capital from Britain to Canada and the United States, among other countries, between 1870 and 1914. During that era, the Canadian and American economies were growing rapidly as their populations increased and spread westward and as these nations industrialized. This created a demand for investment spending on railroads, factories, and so on. Meanwhile, Britain had a much more slowly growing population, was already industrialized, and already had a railroad network covering the country. This left Britain with savings to spare, much of which were lent out to Canada, the United States, and other New World economies.

International differences in the supply of funds reflect differences in savings across countries. These may be the result of differences in private savings rates, which vary widely among countries. For example, in 2010 gross private savings were 32.7% of Japan’s GDP, but only 24.6% of Canada’s GDP and 23% of U.S. GDP. They may also reflect differences in savings by governments. In particular, government budget deficits, which reduce overall national savings, can lead to capital inflows.

The loanable funds model helps us understand the direction of net capital flows—the excess of inflows into a country over outflows, or vice versa. The direction of net flows, other things equal, is determined by differences in interest rates between countries. As we saw in Table 19-2, however, gross flows take place in both directions: for example, Canada both sells assets to foreigners and buys assets from foreigners. Why does capital move in both directions?

The answer to this question is that in the real world, as opposed to the simple model we’ve just learned, there are other motives for international capital flows besides seeking a higher rate of interest.

Individual investors often seek to diversify against risk by buying stocks in a number of countries. Stocks in Europe may do well when stocks in Canada do badly, or vice versa, so investors in Europe try to reduce their risk by buying some Canadian stocks, as investors in Canada try to reduce their risk by buying some European stocks. The result is capital flows in both directions.

Meanwhile, corporations often engage in international investment as part of their business strategy—for example, auto companies may find that they can compete better in a national market if they assemble some of their cars locally. Such business investments can also lead to two-way capital flows, as, say, Japanese car makers build plants in Canada even as Canadian transportation companies open support facilities in Japan.

Finally, some countries, including Canada, are international banking centres: people from all over the world put money in Canadian financial institutions, which then invest many of those funds overseas.

The result of these two-way flows is that modern economies are typically both debtors (countries that owe money to the rest of the world) and creditors (countries to which the rest of the world owes money). Due to years of both capital inflows and outflows, at the end of 2012, Canada had accumulated foreign assets worth $2.7 trillion, and foreigners had accumulated assets in Canada worth the same amount, $2.7 trillion.