The capital account is made up of financial transfers between countries. This generally involves direct or portfolio investments by foreign entities. It does not, however, include official reserve transfers.
The current account in the balance of payments consists of international transfers of goods and services. These are generally exports. Unilateral transfers such as charity or relief from debt are also accounted for in this category.
A surplus in the capital account could mean that the country is exporting a great deal of its goods and receiving payment for them. It could also mean that there is a great deal of foreign investment coming into the country. Finally, it could mean that the country is making fewer unilateral transfers to other countries.
In the following examples, the transfers are made in U.S. funds and from U.S. banks for simplicity. There are thus no extra capital transfers or foreign exchange issues.
If a U.S. firm sells $5 million in merchandise, there will be a credit to decrease the total amount of goods and services in the country available for export. There will also be a debit to the capital account to show that members of that country now control $5 million more U.S. dollars than before.
If a Japanese firm purchases a plant in the United States, their will be a debit to the capital account to show that financial assets have changed into American hands through forgone investment. There will also be a credit to the current account to show that goods that the U.S. has produced are now controlled by foreigners.
The law of one price implies that items in different countries will have the same value even if purchased with different currencies.
To compute the exchange rate, we set up a ratio:
PTA375/$2.43 = x number of PTA's/$1.00
To buy $2.43 at an exchange rate of PTA144/$ you must pay 144 X 2.43 = PTA350. But it costs PTA 375 to buy $2.43 of sandwich in Spain. The P...