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What is the “balance of payments”?

Canada’s interactions with the rest of the world are recorded in its balance of payments. The balance of payments has two components: the current account and the capital and financial account. The current account reflects all payments between Canadians and foreigners for goods, services, interest and dividends. A current account deficit means Canadians are paying foreigners more for these things than foreigner are paying Canadians. Such a deficit compels Canada to borrow from foreigners to pay for those items for which it has insufficient foreign receipts to cover. These borrowings are captured in the capital and financial account. To finance a current account deficit, Canada must sell an asset such as a piece of land, a company or some foreign currency, or it must issue foreigners an IOU such as a bond or treasury bill. Since the current and capital accounts must balance, a current account deficit implies an equal and offsetting capital account surplus.

Balance of payment transactions can be thought of as incurring either demand or supply of foreign currency and a corresponding supply or demand of Canadian currency. Current account outflows, to buy foreign goods or pay interest on debt held by foreigners, create a demand for foreign currency to make those payments. Canadian dollars are offered in exchange for this foreign currency unless there is a corresponding demand for Canadian dollars. The most important component of the current account is the merchandise trade. A number of factors influence the performance of Canada’s trade – the most important is the relative pace of demand in the Canadian economy. Strong growth in the U.S. demand for automobiles, raw materials and other products made in Canada boosts exports. Likewise, strong demand in Canada for foreign products boost imports. The competitive position of Canadian firms in foreign markets and foreign firms in Canada also influences trade. A falling Canadian dollar lowers the price of Canadian exports in foreign markets and raises the price of imports in Canada. This boosts exports and depresses imports. A rising dollar has the opposite effect.