Balance of payments is an account of monetary transactions that take place between residents in one country and other residents in the rest of the world over time. The transactions comprise exports and imports of goods, services, financial assets, liabilities, and transfer payments such as foreign aid.
BOP can tell you whether a country has enough to pay for its imports and whether their economic output is sufficient enough to finance its growth. In other words, it’s an indicator of whether an economy is in a deficit or surplus and gives insight to what’s driving that outcome. When a country is in deficit, they import more goods, services, and capital than it exports, while surplus is the opposite.
How It Works
Balance of payments shows the payments and receipts between residents in one country and other international countries. This includes transactions that take place in both private and public sectors.
When a country receives money, it’s known as a credit, and when they pay money to another country, it’s defined as a debit. In an ideal world, credits and debits would balance out making the balance of payments zero. That is seldom the reality, however.
In terms of how balance of payments is recorded, accounting is done using double-entry bookkeeping to record transactions. This means every transaction is recorded as a positive entry in one account and negative in another so the sum comes to zero. For instance, if a U.S. business sells goods to another business in Japan, that would be considered an export and recorded as a credit. Because BOP uses double-entry bookkeeping, the foreign income received from that transaction would be recorded as a debit.
Types of Balance of Payments
BOP has three categories, which include the current account, capital account, and financial account.
Current account
The current account measures the flow of goods and services between residents of a country and residents in the rest of the world. It also records income that is exchanged between residents and non residents of a country. The latter is categorized into two groups of primary and secondary income. Primary income refers to income earned from production, returns on financial assets, or renting natural resources. It also includes things like:
- Salaries paid to workers who are working in a nonresident company in their home country
- Dividends from multinational corporations
- Interest from international loans
Secondary income, on the other hand, refers to income that is redistributed by means of transfers like donations from one government to another or funds immigrants send to their families back home. It also includes income residents get from the government like a tax return.
Capital account
This category tracks international capital transfers of non-financial and non-produced assets. Examples are natural resources like land or minerals. The capital account also comprises capital that is transferred between residents and nonresidents like an inheritance or debt forgiveness between countries.
Financial account
Financial accounts track financial assets and liabilities flowing between residents and nonresidents. The goal is to measure a country’s ownership of foreign assets versus other country’s ownership of their assets. Examples of assets accounted for include stocks, bonds, or real estate.
Calculating BOP
To calculate balance of payments, you first calculate the individual balances of the current, capital and financial accounts. Once that’s complete, you simply add all three numbers together to arrive at a country’s total BOP.
BOP And Economic Growth
The balance of payments can help countries identify opportunities to grow exports and create policies to help support growth. Likewise, BOP can help governments assess import and export tariffs so they can adjust taxes to encourage exports and discourage imports.
Another important function of BOP is it helps inform fiscal and monetary policy. Countries aim to be in surplus as that helps boost economic growth and BOP can help them meet this goal. Ultimately, it’s one of many indicators that can tell how healthy an economy is.
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