Posted by: Ravi Saraogi | May 28, 2010

How the Global Economy functions…

A simple and lucid framework to help you understand the present functioning of the global economy-

Balance of payments of a country can be broken down into two parts- trade balance and capital account balance. Summing up the two parts should give us zero as they are an accounting identity. So,

Trade balance (surplus/deficit) = Exports – Imports

Capital account balance (surplus/deficit) = Capital inflows – Capital outflows

Balance of payments = trade balance + capital account balance

If trade balance is in surplus, the capital account balance will be in deficit of an equal magnitude and if trade balance is in deficit, capital account balance will be in surplus of an equal magnitude (to finance the deficit).

The developed nations (read US, EU) import like crazy from developing nations (read China, India). Thus,

Trade balance (developed nations) = deficit (imports > exports)

Trade balance (developing nations) = surplus (exports>imports)

As we know, the US$ is the world currency. So, if Chindia (China + India) exports, it receives US$. And if it imports, it pays in US$. Since exports > imports for Chindia, these guys are getting more dollars than using them. So, they are accumulating dollars.

What does Chindia do with these dollars? They need a safe avenue to invest them, and what can be more safe than the US govt bonds. So Chindia buys US govt bonds (which the US govt issues to finance its deficit).

So,

Capital account balance (developed nations) = surplus (inflow of dollars from Chindia that buy US govt bonds)

Capital account balance (developing nations) = deficit (outflow of dollars for buying dollar denominated US govt bonds)

These capital account surplus/deficit offset the surplus/deficit trade balance.

In summary,

Chindia produces, ย sends the good for US consumption and accumulates dollar. The US consumes. And in huge quantities. It starts running a deficit and has to print bonds to finance the deficit. These same bonds are then bought by Chindia, so the dollars come back to the US. The US can now again buy from Chindia and Chindia can now again start exporting to the US.

And the cycle continues…..

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Responses

  1. Sacrifice or Murder?…

    I found your entry interesting thus I’ve added a Trackback to it on my weblog :)…

  2. @Rajeev – thank you very much ๐Ÿ™‚ had a look at your website… are u a journalist?

  3. Ravi, the way of your writing is very simple so that everybody (including non-economist) can understand.

    Good work.

  4. @Sathiya – thank you very much sathiya… hope you are doing well….

  5. Dude,
    It is a very good article. I had some doubt about balance of payments for long time, but now I have understood clearly….thanks for posting..looking for more from you!!!…………..

  6. @ Ramesh – thanks machi…. I have mentioned in the article that BOP must always balance, as it is an accounting identity… Generally, this can come as a surprise to many as time and again we come across terms like ‘the country is suffering from balance of payments deficit’….. When we come across terms like this, is should be understood that ‘balance of payments deficit’ being referred to excludes accommodating foreign exchange transactions and include only autonomous foreign exchange transactions… If both accommodating and autonomous transactions are included, the overall BOP can never be in surplus or deficit…

    I will explore more on this aspect in a subsequent post so that we have a full understanding of the external accounts of a country…

  7. nice Ravi…though I was aware of the same…but it is a good recap..and need I mention that you are extremely lucid with your language ๐Ÿ™‚ Good job…and best of luck for the exam!! ๐Ÿ™‚

  8. The title told me it was going to be something about the dark side of the financial world…But I was wrong…

    Golu sounds like some professor. I know it all, but kid, good to see you write again…heehee..

    I have noticed your fascination with accounting identities. since by definition, it always has to hold, no matter what, u find something magical about them..when assets did not match liabilities in school, we would create a ‘suspense’ account….i used to always create one actually ๐Ÿ˜‰

    Would love to read something about how the global economy falls and rises. Clearly, the scope of identities here is quite limited.

    Keep writing!


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