The financial account is one of the components of the balance of payments. It shows the net acquisition and disposal of both financial assets and liabilities. As stated in the sixth edition of the Balance of Payments Manual (BPM), by the International Monetary Fund, “The financial account records transactions that involve financial assets and liabilities and that take place between residents and nonresidents”. The table below, taken from the BPM, shows an overview of the financial account.

The financial accounts may correspond to either entries to goods, services, income or capital account, or to entries of opposite sign to the financial account itself. For instance, when a country sells goods to another country, there will be an entry in the current account (an increase in the goods and services account, since the country is exporting), but also an entry in the financial account, such as currency, deposits or trade credit. Sometimes, entries in the financial account will be matched by other entries in the same account: bonds may be exchanged for deposits or currency.

Therefore, the balances of both the current account and the capital account will be conceptually equal to the net balance of the financial account, as seen in the following formula:

CAB + KAB = NFA

where:

CAB = current account balance
KAB = capital account balance
NFA = net financial account

This must be understood as follows: the sum of the balances on the current and capital accounts represent the surplus(net lending) or deficit(net borrowing) that an economy has with the rest of the world. This is equal to the financial account, since it measures how the net lending or borrowing from non-resident is financed.

Net capital outflows (NCOs, also called net foreign investment) make reference to the difference between the acquisition of foreign assets by domestic residents and the acquisition of domestic assets by non-residents. Therefore, it has to do with savings and investment (loanable funds) and foreign currency exchange.

The relationship between net capital outflows and foreign currency exchange can be easily seen using a model, which analyses the market for loanable funds and the market for foreign currency exchange, in the context of an open economy. The link between these two markets will be net capital outflows. Let’s start by defining each market.

The market for loanable funds

In a few words, this market is a simplified view of the financial system. All savers come to the market for loanable funds to deposit their savings. Also, everyone looking for a loan (either to spend it or to invest it) comes to this market. In order to see how the supply and demand of loanable funds work, we use the following identity:

S = I + NCO

where

S = savings
I = domestic investment
NCO = net capital outflows

Savings corresponds to everything an economy saves from its income, both from the private sector and government accounts. Therefore, it represents national savings. On the other side of the identity we have national investment and net capital outflows. In other words, on one side we have savings being supplied to the market, while on the other side we have money demanded for national investment and net foreign investment (net capital outflows). As seen in the adjacent figure, equilibrium is reached when the quantity of savings (which correspond to supply of loanable funds) equals investment and net capital outflows (demand for loanable funds).

The supply for loanable funds (S_LF) curve slopes upward because the higher the real interest rate, the higher the return someone gets from loaning his or her money. The demand for loanable funds (D_LF) curve slopes downward because the higher the real interest rate, the higher the price someone has to pay for a loan.

The market for foreign currency exchange

In order to understand this market, which is the market in which domestic currency (let’s say euros) is exchanged for foreign currencies, we must use another identity:

NX = NCO

where

NX = net exports
NCO = net capital outflows

Again, if the economy is running a trade deficit (NX<0), it must be financing the net purchase of goods and services by selling assets abroad, so foreign capital is entering the economy (NCO<0). In order to buy domestic assets, foreign economies must exchange their currencies into euros, which increases the demand for euros. If the economy is running a trade surplus (NX>0), the excess in foreign currency it receives is being used to buy assets from abroad, which means domestic capital is flowing out of the economy (NCO>0). In this case, residents must exchange their euros for foreign currency, which increases the supply of euros, as seen in the adjacent figure.

The equilibrium is determined by the real exchange rate, since it corresponds to the relative price of domestic and foreign goods, thus affecting net exports. The supply of euros (S_€, derived from net capital outflows) curve is vertical because it does not depend on the real exchange rate (as seen before, it depends on real interest rate, which is considered as given in this market). The demand for euros (D_€, derived from net exports) curve slopes downwards because the higher the real exchange rate, the more expensive European goods are for foreign economies, thus reducing the quantity of euros demanded to buy those goods (since less people wants to buy European goods).

Net capital outflow

Net capital outflow links both markets. It does so because it depends on real interest rates, and because it determines the supply of euros. As we can see in the figure below, the net capital outflow curve slopes downwards. This is because the higher domestic real interest rates, the more attractive our assets are. This will attract foreign investment, which will in turn reduce net capital outflow (since more capital is entering the economy).

The equilibrium

As seen in the figure below, the equilibrium is guaranteed by net capital outflows. The supply and demand for loanable funds determines a total quantity of loanable funds, but also a real interest rate, which in turn affects net capital outflows. Supply and demand of euros determine the real exchange rate, which also affects net capital outflows.

As we can see, these two markets and the net capital outflows linking them are tightly interconnected. In order to understand how this model can become a really useful tool, let’s review a few scenarios to see how the model responds.

Effects of budget deficits, trade policies and political instability

–Government budget deficit: when a government runs a budget deficit, it reduces the quantity of available loanable funds, thus shifting S_LF to the left. This happens because the government’s expenses surpass its revenues. Therefore, it has negative savings, which reduces total savings. Shifting the supply of loanable funds reduces the total quantity at equilibrium, but also increases the real interest rate (to i₁). This increase of the real interest rate reduces net capital outflow. The reduction of net capital outflow decreases the quantity of euros being supplied to be exchanged for foreign currency, which ultimately causes the real exchange rate to appreciate.

-Trade policy: let’s see how import quotas affect the market for loanable funds. Since an import quota reduces imports at any real exchange rate, net exports rise. Therefore, foreigners will need to buy more euros to buy EU net exports, which will shift the demand for euros (D_€) to the right. This will appreciate the real exchange rate, but will have no effect on the market for loanable funds, and therefore the real interest rate will remain the same. Since the real interest rate does not change, neither do net capital outflows. However, the appreciation of the euro will increase imports and decrease exports (domestic goods are more expensive relative to foreign goods). This will gradually return the demand for euros (D_€) to its initial state. Therefore, we can conclude that trade policies do not affect the trade balance.

-Political instability: this can easily turn into capital flights, such as the ones lived in Mexico in 1994, in some Asian countries in the late nineties, or the one that ultimately caused the Argentinian crisis of 2001. Capital flights basically mean that large quantities of assets or money are leaving an economy, which will shift the net capital outflow curve upwards, to show increasing net capital outflows. This will affect both the market for loanable funds and the market for foreign currency exchange. First, it will increase the demand for loanable funds (in order to increase the purchase of assets overseas), shifting the demand curve (D_LF) to the right, increasing the real interest rate. Secondly, since people wants to convert their euros into a more “secure” currency, supply of euros rapidly increases, shifting the supply curve to the right.

The IS-LM-BP model (also known as IS-LM-BoP or Mundell-Fleming model) is an extension of the IS-LM model, which was formulated by the economists Robert Mundell and Marcus Fleming, who made almost simultaneously an analysis of open economies in the 60s. Basically we could say that the Mundell-Fleming model is a version of the IS-LM model for an open economy. In addition to the balance in goods and financial markets, the model incorporates an analysis of the balance of payments.

Even though both economists researched about the same topic, at about the same time, both have different analyses. Mundell’s paper “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates”, 1963, analyses the case of perfect mobility of capital, while Fleming´s model, depicted in his article “Domestic Financial Policies under Fixed and under Floating Exchange Rates”, 1962, was more realistic as it assumed imperfect capital mobility, and thus made this one a more rigorous and comprehensive model. However, nowadays, his model has lost cogency, as the actual world situation has more resemblance with total capital mobility, which corresponds better to Mundell’s view.

In order to understand how this model works, we’ll first see how the IS curve, which represents the equilibrium in the goods market, is defined. Secondly, the LM curve, which represents the equilibrium in the money market. Thirdly, the BP curve, which represents the equilibrium of the balance of payments. Finally, we’ll analyse how the equilibrium is reached.

IS curve: the market for goods and services

In an open economy, the equilibrium condition in the market for goods is that production (Y), is equal to the demand for goods, which is the sum of consumption, investment, public spending and net exports. This relationship is called IS. If we define consumption (C) as C = C(Y-T) where T corresponds to taxes, the equilibrium would be given by:

Y = C (Y- T) + I + G + NX

We consider that investment is not constant, and we see that it depends mainly on two factors: the level of sales and interest rates. If the sales of a firm increase, it will need to invest in new production plants to raise production; it is a positive relation. With regard to interest rates, the higher they are, the more expensive investments are, so that the relationship between interest rates and investment is negative. Now, in addition to what we have in the IS-LM model, since we have net exports, we have also to take into account the exchange rates, which directly affect net exports. Let’s say e is the domestic price of foreign currency or, in other words, how many units of our own currency have to be given up to receive 1 unit of the foreign currency. The new relationship is expressed as follows (where i is the interest rate):

Y = C (Y- T) + I (Y, i) + G + NX(e)

If we keep in mind the equivalence between production and demand, which determines the equilibrium in the market for goods, and observe the effect of interest rates, we obtain the IS curve. This curve represents the value of equilibrium for any interest rate.

An increasing interest rate will cause a reduction in production through its effect on investment. Therefore, the curve has a negative slope. The adjacent graph shows this relationship.

As stated before, we also need to analyse changes in exchange rates (here, e). If e decreases, then we’ll be able to buy more foreign currency with less of our own currency. On the other hand, foreigners we’ll need to pay more of their currency to buy our own. Therefore, when e decreases, also called an appreciation under flexible exchange rates or a revaluation under fixed exchange rates, domestic residents have more purchasing power, thus being able to buy the same amount of goods using less domestic currency. The opposite works in the same way: if e increases (also called a depreciation under flexible exchange rates or a devaluation under fixed exchange rates), domestic residents will pay more for the same goofromTo sum up, an increase in e causes net exports to increase (IS curve shifts to the right) and a decrease in e causes net export to decrease (IS curve shifts to the left).

LM curve: the market for money

The LM curve represents the relationship between liquidity and money. In an open economy, the interest rate is determined by the equilibrium of supply and demand for money: M/P=L(i,Y) considering M the amount of money offered, Y real income and i real interest rate, being L the demand for money, which is function of i and Y. Also, the exchange rate must be analysed since it affects money demand (investors may decide buy or sell bonds in a country depending on the exchange rate).

The equilibrium of the money market implies that, given the amount of money, the interest rate is an increasing function of the output level. When output increases, the demand for money raises, but, as we have said, the money supply is given. Therefore, the interest rate should rise until the opposite effects acting on the demand for money are cancelled, people will demand more money because of higher income and less due to rising interest rates.

The slope of the curve is positive, contrary to what happened in the IS curve. This is because the slope reflects the positive relationship between output and interest rates.

BP curve: the balance of payments

The BP curve shows at which points the balance of payments is at equilibrium. In other words, it shows combinations of production and interest rates that guarantee that the balance of payments is viably financed, which means that the volume of net exports that affect total production must be consistent with the volume of net capital outflows. It will usually slope up since the higher the production, the higher the imports, which will disturb the equilibrium of the balance of payments, unless interest rates rise (which would cause capital inflows to maintain the equilibrium). However, depending in how great the mobility of capital is, it will have a greater or smaller slope: the higher the mobility, the flatter the curve.

Once the BP curve is derived, there is an important thing to know about how to use it. Any point above the BP curve will mean a balance of payments surplus. Any points below the BP curve will mean a balance of payments deficit. This is important since depending where we are, different things may affect the interest rates.

The IS-LM-BP model

In the model we distinguish between perfect and imperfect capital mobility, but also between fixed and flexible exchange rates. For each of these cases, we’ll see what happens when both an expansionary monetary and fiscal policy are applied to the economy. We’ll first review Mundell’s model, which deals with perfect mobility. Then, we’ll analyse Fleming’s imperfect mobility model.

1 Perfect capital mobility

1.1 Fixed exchange rate

An expansionary monetary policy will shift the LM curve to LM’, which makes the equilibrium go from point E₀ to E₁. However, since we are below the BP curve, we know the economy has a balance of payments deficit. Since exchange rates are fixed, government intervention is required: the government will purchase domestic currency and sell foreign currency, which will drop the money supply and therefore shift the LM’ curve to its original position (which makes the equilibrium go to E₂). Monetary policy has therefore no effect under these circumstances.

An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium form point E₀ to point E₁. Since the economy has now a balance of payments surplus, and because the exchange rate is fixed, government will intervene in the exact opposite way: they’ll purchase foreign currency and sell domestic currency. This will increase the money supply, shifting the LM curve to the right. The final equilibrium is reached at point E₂ where, at the same interest rate, production has increased greatly: fiscal policy works perfectly under these circumstances.

1.2 Flexible exchange rate

An expansionary monetary policy will shift the LM curve to LM’, which makes the equilibrium go from point E₀ to E₁. However, since now exchange rates are flexible, we have a different situation: the balance of payments deficit will depreciate the domestic currency. This will increase net exports (since foreigners can now buy more of our products with the same amount of money), which will shift the IS curve to the right (to IS’). The final equilibrium is reached at point E₂ where, at the same interest rate, production has increased greatly: monetary policy works perfectly under these circumstances.

An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium from point E₀ to point E₁. The economy will therefore have a balance of payments surplus, which in this case of flexible exchange rate will appreciate the domestic currency. This will decrease net exports, since we are able to import more goods and services with less money, while foreigners will import less of our products because of our appreciated domestic currency. This drop in net exports will shift the IS’ curve back to its original position. Since now the final equilibrium E₂ corresponds to the initial equilibrium, we know fiscal policy is no good in this case.

It is easy to see why Mundell devised what is known as the impossible trinity. In a few words, no economy can have the following three: perfect capital mobility, fixed exchange rates and an independent and efficient monetary policy. Under the perfect capital mobility assumption, and in order to have an efficient monetary policy, exchange rates must be flexible. Or have fixed exchange rates but assume that monetary policy won’t be efficient.

2 Imperfect capital mobility

2.1 Fixed exchange rate

Here we have the exact same situation as before: an expansionary monetary policy will shift the LM curve to LM’, which makes the equilibrium go from point E₀ to E₁. However, since we are below the BP curve, we know the economy has a balance of payments deficit. Since exchange rates are fixed, the government will purchase domestic currency and sell foreign currency, which will drop the money supply and therefore shift the LM’ curve to its original position (which makes the equilibrium go to E₂). Monetary policy has again no effect, no matter how great or small capital mobility is.

An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium from point E₀ to point E₁. Now, depending on capital mobility, we’ll either have a balance of payments surplus (high capital mobility, BP+ curve) or a balance of payments deficit (small capital mobility, BP- curve). Since exchange rates are fixed, government will need to intervene: its acquisitions and disposals of both domestic and foreign currency will shift the LM curve to either LM’ or to LM* (you can review what happens above: a balance of payments surplus is the same scenario as in a fiscal policy with perfect capital mobility and fixed exchange rates, while the balance of payments deficit corresponds to the monetary policy scenario). Under these circumstances, fiscal policy is completely efficient. It’s actually the more efficient the higher capital mobility is.

2.2 Flexible exchange rate

An expansionary monetary policy will shift the LM curve to LM’, which makes the equilibrium go from point E₀ to E₁. However, since now exchange rates are flexible, the balance of payments deficit will depreciate the domestic currency. This will increase net exports, shifting the IS curve to IS’. Also, since domestic assets are less expensive, the BP curve will shift to the right (to either BP’+ or BP’-). Therefore, with high capital mobility, final equilibrium will be at point E₂. Monetary policy works well under these assumptions. It’s actually the more efficient the higher capital mobility is.

An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium from point E₀ to point E₁. Now, depending on capital mobility, we’ll either have a balance of payments surplus (high capital mobility, BP+ curve) or a balance of payments deficit (small capital mobility, BP- curve). In the case of a balance of payments surplus, and considering flexible exchange rates, there will be an appreciation of the domestic currency. This will decrease net exports, which will shift the IS’ curve to the left. Also, since domestic assets are more expensive, the BP+ curve will shift to the left. The final equilibrium will therefore be at point E₂. If there is a balance of payments deficit (the case for the BP- curve), the result will be the same one as in the monetary policy case (being E₂* the final equilibrium). In this scenario, fiscal policy will be more efficient the smaller capital mobility is.

The Mundell-Fleming model is a very useful tool when dealing with the analysis of open economies. A great deal of textbooks and papers argue for or against each of these models. However, there’s no denying the world is moving towards liberalizing international trade and capital movements (mostly through WTO’s agreements), which would make us lean towards Mundell’s view. To sum up, under perfect capital mobility, monetary policy will only work with flexible exchange rates, while fiscal policy will only work with fixed exchange rates.

The IS-LM (Investment Savings-Liquidity preference Money supply) model focuses on the equilibrium of the market for goods and services, and the money market. It basically shows the relationship between real output and interest rates.

It was developed by John R. Hicks, based on J. M. Keynes’ “General Theory”, in which he analysed four markets: goods, labour, credit and money. This model, firstly named IS-LL, appeared in his article “Mr. Keynes and the Classics: a Suggested Interpretation”, published in 1937 in the journal Econometrica.

In order to understand how this model works, we’ll first see how the IS curve, which represents the equilibrium in the goods market, is defined. Then, the LM curve, which represents the equilibrium in the money market. Finally, we’ll analyse how the equilibrium is reached.

IS curve: the market for goods and services

In a closed economy, the equilibrium condition in the market for goods is that production (Y), is equal to the demand for goods, which is the sum of consumption, investment and public spending. This relationship is called IS. If we define consumption (C) as C = C(Y-T) where T corresponds to taxes, the equilibrium would be given by:

Y = C (Y- T) + I + G

We consider that investment is not constant, and we see that it depends mainly on two factors: the level of sales and interest rates. If the sales of a firm increase, it will need to invest in new production plants to raise production; it is a positive relation. With regard to interest rates, the higher they are, the more expensive investments are, so that the relationship between interest rates and investment is negative. The new relationship is expressed as follows (where i is the interest rate):

Y = C (Y- T) + I (Y, i) + G

If we keep in mind the equivalence between production and demand, which determines the equilibrium in the market for goods, and observe the effect of interest rates, we obtain the IS curve. This curve represents the value of equilibrium for any interest rate.

An increasing interest rate will cause a reduction in production through its effect on investment. Therefore, the curve has a negative slope. The adjacent graph shows this relationship.

LM curve: the market for money

The LM curve represents the relationship between liquidity and money. In a closed economy, the interest rate is determined by the equilibrium of supply and demand for money: M/P=L(i,Y) considering M the amount of money offered, Y real income and i real interest rate, being L the demand for money, which is function of i and Y.

The equilibrium of the money market implies that, given the amount of money, the interest rate is an increasing function of the output level. When output increases, the demand for money raises, but, as we have said, the money supply is given. Therefore, the interest rate should rise until the opposite effects acting on the demand for money are cancelled, people will demand more money because of higher income and less due to rising interest rates.

The slope of the curve is positive, contrary to what happened in the IS curve. This is because the slope reflects the positive relationship between output and interest rates.

IS-LM model

At any point of these curves the equilibrium condition in the corresponding market is true, but only at the point where the two curves intersect, both equilibrium conditions are satisfied. We can see this intersection in the following graph:

The IS and LM curves undertake changes due to many factors, such as different kinds of economic policies. These variations will explain the changes in the values of production and of interest rates taking place in the economies.
For instance, if there is an increase in government spending, which is considered a fiscal policy, the IS curve will shift to the right, as seen in the graph in the left. This happens because more government spending means more production for any interest rate. This shift, as seen in the adjacent graph, will consequently change the equilibrium from point E₁ to point E₂, with a greater level of output, but also at greater interest rates.

On the other hand, if we consider a monetary policy, such as an increase in the money supply, the curve that shifts will be the LM curve, as seen in the graph in the right. An increase in the money supply will decrease the interest rate, shifting the LM curve to the right, thus increasing output.

Monetarists’ views on the IS-LM model:

Monetarists greatly criticized the IS-LM model, highlighting some different views regarding the elasticity (and therefore the slope) of both curves. In their opinion, the LM curve is very inelastic, while the IS curve is very elastic. The most important thing we derive from these different views is the different consequences and effectiveness of expansionary fiscal and monetary policies.

Monetarists argue that monetary policies are more effective. Take the same example as before, an increase in the money supply. This will shift the LM curve to the right, displacing the equilibrium from E₁ to E₂ in the figure below. However, monetarists consider also two other effects: direct and indirect wealth effect. The first one, also known as Pigouvian effect, considers that, because of the increase in money supply, people will consume more, shifting the IS curve and changing the equilibrium to point E₃. The second one considers that, because of the initial drop in the equilibrium interest rates, people will invest more, thus shifting even more the IS curve and changing the equilibrium to point E₄.

Now, monetarists are more sceptic than Keynesians about fiscal policy. This is because, as seen in the figure below, the initial shift of the IS curve (from point E₁ to point E₂) will be partly offset by a second shift of the same curve. This, known as crowding-out, happens because the increase in government spending increases interest rates, which decreases the attractiveness of investment. Therefore, the more the government spends, the less private capital will be invested, which moves the equilibrium from point E₂ to E₃. Also, because of higher output, money demand increases, which shifts the LM curve to the left, to point E₄.

Both views have a great army of researchers and professors defending them, as part of the modern division on such matters into two main doctrines: New Keynesian Economics and New Classical Macroeconomics. All the effects presented here must be taken into consideration when analysing the IS-LM model. However, it must be noted that some of these conclusions change when considering an open economy, which is analysed by the IS-LM-BoP or Mundell-Fleming model.

The capital account is one of the components of the balance of payments. It mainly reflects net foreign holdings of capital. When a country incurs on a deficit on current account, it needs to be financed by capital from abroad, it needs to have a capital account surplus. The opposite occurs in the case of current account surplus, there will be an outflow of capital to foreign countries. As stated in the sixth edition of the Balance of Payments Manual (BPM), by the International Monetary Fund, “the capital account in the international accounts shows (a) capital transfers receivable and payable between residents and nonresidents and (b) the acquisition and disposal of nonproduced, nonfinancial assets between residents and nonresidents”.

In other words, the capital account shows acquisitions and disposals of nonproduced nonfinancial assets, such as the sales of leases and licenses, as well as capital transfers (when one party provides capital resources without anything of economic value being supplied as a counterpart). The table below, taken from the BPM, shows an overview of the capital account.

The current account is one of the components of the balance of payments. It mainly shows the value of movements in exports and imports and income derived form transactions related to net purchases of goods and services. As stated in the sixth edition of the Balance of Payments Manual (BPM), by the International Monetary Fund, “the current account shows flows of goods, services, primary income, and secondary income between residents and nonresidents”. Let’s review all these components:

“The goods and services account shows transactions in items that are outcomes of production activities”. The first thing to mention is that, even though goods are physical, and services are a production that changes the consuming units, or facilitates some kind of exchange, both are considered as products, and are measured at the moment of exchange and at market value. The table below, taken from the BPM, shows an overview of the goods and services account.

“The primary income account shows primary income flows between resident and nonresident institutional units”. In other words, these are income flows concern to some extent governments and other institutions. For instance, taxes, subsidies or other income associated with the production process and with the ownership of financial assets and renting natural resources. It’s worth mentioning that cross-border primary income flows constitute a link between gross domestic product and gross national income. The table below, taken from the BPM, shows an overview of the primary income account.

“The secondary income account shows current transfers between residents and nonresidents”. These transfers, which might be in cash or in kind, do not include capital transfers, which are shown in the capital account. This is because, as opposed to secondary income, capital transfers do not affect disposable income. The table below, taken from the BPM, shows an overview of the secondary income account.

The balance on these three account is known as the current account balance, which shows the difference between the sum of exports and income receivable, and the sum of imports and income payable. It’s also worth mentioning that the current account balance equals the savings-investment gap for the economy, as seen in the following formula:

S – I = CAB

where

S = savings

I = investment

CAB = current account balance

The balance of payments consists of a series of accounts that reflect the transactions made between an open economy and the rest of the world. As stated in the sixth edition of the Balance of Payments Manual, by the International Monetary Fund, “the balance of payments [is] a statement that summarizes economic transactions between residents and nonresidents during a specific time period”.

These international accounts, which grow greater every day thanks to globalization, are harmonized with the System of National Accounts, so comparisons can be made. They provide a broad view required for the analysis of international trade, exchange rate regimes, and the economic relation between countries, which may translate into vulnerabilities. Therefore, it is of great importance to understand them so business cycles can be anticipated and its consequences diminished.

The balance of payments “consists of the goods and services account, the primary income account, the secondary income account, the capital account, and the financial account”. The first three components form what is known as the current account balance, which mainly shows movements in goods and services and income derived form transactions related to these. The capital account is the sum of two accounts: capital transfers between residents and non-residents; and credit and debit entries for nonfinancial assets. Finally, the financial account shows net acquisitions and disposals of financial assets and liabilities.

The relationship between these accounts is shown in the following formula:

CAB + KAB = NFA

where

CAB = current account balance

KAB = capital account balance

NFA = net financial account

This must be understood as follows: the sum of the balances on the current and capital accounts represent the surplus (net lending) or deficit (net borrowing) that an economy has with the rest of the world. This is equal to the financial account, since it measures how the net lending or borrowing from non-resident is financed.