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Balance of Payments question

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echoprodigy Posted: Sun, Jan 27 2008 12:45 PM

I had difficulty understanding the role of the "Change in Reserves" at the bottom of the balance of payments. "It's like the money in your savings account," explained my teacher, "it covers your shortfall in your checking account, your "current" account."  Uh... huh?

Then why doesn't it simplify? As an engineering student, I've been taught to idealize formulas to understand them more easily. The balance of payments is an aggregate amount, incorporating every individual, corporation and government transaction with the outside world.

So let's simplify:

I run a balance of trade deficit with China.

I bought a computer, worth $1000 from Lenovo. Imports, $1000, Exports 0.
Services trade is 0, I neither import nor export anything. I don't invest there, and they don't invest in me, so the capital account is also 0.

At the end of the day, my balance of payments is -$1000. Why does the Federal reserve system need to spend $1000 to compensate for my expenditure, and where does that money go?

Near as I can tell, they spend that money to keep the supply of money in the US the same, now that I've given $1000 to some Chinaman, who, in turn, puts it in a bank where it ultimately winds up in his country's reserves. But that's not how she explained it. In fact, her answer made so little sense that I can't regurgitate it because my brain has already flushed that information.

Am I right? Do I have something confused?

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