[MUSIC] To begin our study of international trade, let's learn some basic balance of payments accounting. We can start by distinguishing between the so-called current account and the capital account, and then illustrate the critical relationship between the two. This relationship is summarized in the so-called Trade Identity Equation. It says that if a country runs a trade deficit in its current account, it must balance that deficit with inflows into its capital account. It is illustrated in this table, which presents the US Balance of Payments schedule for a typical year. From the table, we can see that the current account consists of three major items. The merchandise trade balance, fees for services and net investment income. The merchandise trade balance is by far the biggest item. It reflects trade in commodities such as food and fuels and manufactured goods. In the table, the US shows accounting debits or imports of $803 billion, and credits or exports of $612 billion. Subtracting one from the other, we have a net merchandise trade deficit of negative $190 billion. When you read in the newspaper that the US is running a trade deficit, it is this merchandise trade balance to which journalists often are referring. But this is only part of the total picture. The second item in the current account is fees for services. Such services include shipping, financial services and foreign travel. While this fee's category is much smaller than the merchandise trade balance, it has been growing in recent years as the US has shifted from a manufacturing economy to a more service-oriented economy. This growth has helped offset at least some of the large merchandise trade deficits, as is evident from the table. In particular, the service fees received by the US are $237 billion, and fees paid out are $157 billion, yielding a net surplus of $80 billion. This, in turn, yields a net balance for goods and services of negative $111 billion. Still a third item in the current account is investment income. The table shows a credit of $206 billion. This represents the amount of income earned by Americans holding foreign assets, while the debit $203 billion represents the amount of income earned by foreigners holding US assets. Historically, this category has run a small surplus for the US. However, as foreigners have continued to accumulate more and more US assets, this category is starting to run in the red, further exacerbating the trade deficit. Finally, the fourth item in the current account is unilateral transfers, which represent payments not in return for goods and services. Now, summing these four items in the table, we wind up with the balance on the current account. This shows a deficit of $148 billion. As indicated above by the basic trade identity, this deficit must be offset by a net surplus in the capital account. One part of the capital account shows official reserve changes. When all countries have purely market-determined exchange rates, the category equals zero. However, when countries intervene in foreign exchange markets, as we shall explain more about soon, they attempt to affect the exchange rate by buying and selling foreign currencies. This shows up in the balance of payments as changes in official reserves. However, as you can see from the table, this is a small category, only $7 billion. A far greater consequence are the capital out-flows and in-flows, which track the purchases of both real assets like hotels and factories, and financial assets such as stocks and bonds. For example, foreign purchases of US assets represent capital in-flows, and might include the purchase of government bonds by a German pension fund, the buying of American stock by a Dutch mutual fund, or the acquisition of a factory in a Pennsylvania by Japanese investors. In our table, we show a credit of 517 billion. Similarly, when US investors purchase assets abroad, like hotel chains or foreign stocks, this results in capital out-flows and a debit, such as the $376 billion represented in the table. And summing US and foreign purchases of assets, we get a balance of $141 billion. Of course, when we add official reserves to this sum, we come up with a plus $148 billion. This is just enough to offset the current account deficit, and make the sum of the current and capital accounts equal to zero, just as our basic trade identity equation requires
