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Balance of Payments

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Balance of Payments

The balance-of-payments theory forgets that the volume of foreign trade is completely dependent upon prices; that neither exportation nor importation can occur if there are no differences in prices to make trade profitable.¹

The trade of goods and services is an important factor when it comes to the balance of payments, which indeed, is very important for every country’s economy. What is the balance of payments and how does foreign trade affect it? Let’s learn about the balance of payments, its components, and why it is important for every nation.

The Balance of Payments (BOP) is a statement recording all the financial transactions made between the residents of a country and the rest of the world over a certain period, such as over a quarter of a year or a year.

What is the balance of payments?

The Balance of Payments (BOP) summarises a nation’s economic transactions, such as exports and imports of goods, services, and financial assets, along with transfer payments with the rest of the world. It is also known as the balance of international payments and it includes all the transactions among individuals, corporations, and governments between countries. The BOP helps in monitoring the flow of money and developing the economy.

The balance of payments has three components: the current account, the capital account, and the financial account. You can see them in Figure 1.

Balance of Payments Balance of Payments Components StudySmarterFigure 1. Balance of Payments, StudySmarter Originals

Current account

The current account indicates the country’s economic activity. The current account is divided into four main components, which record the transactions of a country's capital markets, industries, services, and governments. The four components are:

  1. Balance of trade in goods. Tangible items are recorded here.
  2. Balance of trade in services. Intangible items like tourism are recorded here.
  3. Net income flows (primary income flows). Wages and investment income are examples of what would be included in this section.
  4. Net current account transfers (secondary income flows). Government transfers to the United Nations (UN) or European Union (EU) would be recorded here.

The current account balance is calculated using this formula:

Current Account = Balance in trade + Balance in services + Net income flows + Net current transfers

The current account can either be in a surplus or deficit.

Capital account

The capital account refers to the transfer of funds associated with buying fixed assets, such as land. It also records transfers of immigrants and emigrants taking money abroad or bringing money into a country. The money the government transfers, such as debt forgiveness, is also included here.

Debt forgiveness refers to when a country cancels or reduces the amount of debt it has to pay.

Financial account

The financial account shows the monetary movements into and out of the country.

The financial account is split into three main parts:

  1. Direct investment. This records the net investments from abroad.
  2. Portfolio investment. This records financial flows such as the purchasing of bonds.
  3. Other investments. This records other financial investments such as loans.

The balancing item in the balance of payments

As its name states, the balance of payments should balance: the flows into the country should equal the flows out of the country.

If the BOP records a surplus or a deficit, it is called a balancing item, as there are transactions that were failed to be recorded by statisticians.

The balance of payments and goods and services

What is the relationship between the balance of payments and goods and services? The BOP records all the trades of goods and services conducted both by the public and private sectors, to determine the amount of money flowing into and out of the country.

The trade of goods and services determines whether the country has a deficit or surplus balance of payments. If the country is able to export more goods and services than it imports, this means that the country is experiencing a surplus. On the contrary, a country that must import more than it exports is experiencing a deficit.

Trade of goods and services is, therefore, an important part of the balance of payments. When a country exports goods and services, it gets credited to the balance of payments, and when it imports, it gets debited from the balance of payments.

Examples of the balance of payments

Understanding the BOP will be much easier if we consider a few examples.

We will look at two parts of the UK’s BOP: the current account and the financial account from 2017 to 2021.

1. The current account of the UK from the first quarter of 2017 to the third quarter of 2021:

Balance of Payments Uk current account as a percentage of GDP StudySmarterFigure 2. UK’s current account as a percentage of GDP | Created with data from the UK Office for National Statistics, ons.gov.uk, StudySmarter Originals

Figure 2 above represents the UK’s current account balance as a percentage of gross domestic product (GDP).

As the graph illustrates, the UK’s current account always records a deficit, with the exception of the fourth quarter in 2019. The UK has had a persistent current account deficit for the past 15 years. As we can see, the UK always runs a current account deficit, mainly because the country is a net importer. Thus, if the UK’s BOP is to balance, its financial account must run a surplus. The UK is able to attract foreign investment, which allows the financial account to be in a surplus. Therefore, the two accounts balance out: the deficit is cancelled by the surplus.

2. The break down of the UK's current account from the first quarter of 2017 to the third quarter of 2021:

Balance of Payments UK current account breakdown as percentage of GDP StudySmarterFigure 3. UK’s current account breakdown as a percentage of GDP | Created with data from the UK Office for National Statistics, ons.gov.uk, StudySmarter Original

As mentioned earlier in the article, the current account has four main components. In Figure 3 we can see the breakdown of each component. This graph illustrates the loss of competitiveness of UK goods and services, as they always have a negative value, with the exception of 2019 Q3 to 2020 Q3. Since the de-industrialisation period, UK goods have become less competitive. Lower wages in other countries also fuelled the decline in the competitiveness of UK goods. Because of that, fewer UK goods are demanded. The UK has become a net importer, and this causes the current account to be in a deficit.

How to calculate the balance of payments

This is the balance of payments formula:

Balance of Payments = Net Current Account + Net Financial Account + Net Capital Account + Balancing Item

Net means the value after accounting for all expenses and costs.

Let's take a look at an example calculation.

Balance of Payments Calculating the balance of payments StudySmarterFigure 4. Calculating the Balance of Payments, StudySmarter Original

Net current account: £350,000 + (-£400,000) + £175,000 + (-£230,000) = -£105,000

Net capital account: £45,000

Net financial account: £75,000 + (-£55,000) + £25,000 = £45,000

Balancing item: £15,000

Balance of Payments = Net Current Account + Net Financial Account + Net Capital Account + Balancing Item

Balance of payments: (-£105,000) + £45,000 + £45,000 + £15,000 = 0

In this example, the BOP equals zero. Sometimes it might not equal zero, so don’t be put off by that. Just ensure that you have double-checked your calculation.

Practise with the flashcards to better your understanding of the Balance of Payments. If you feel confident, go on to read more about the BOP Current Account and the BOP Financial Account in more depth.

Balance of Payments - Key takeaways

  • The balance of payments summarises all the financial transactions made between the residents of a country and the rest of the world over a certain period.

  • The balance of payments has three components: the current account, the capital account, and the financial account.
  • The current account provides an indication of the country's economic activity.
  • The trade of goods and services determines whether the country has a deficit or surplus balance of payments.

  • Balance of Payments = Current Account + Financial Account + Capital Account + Balancing Item.

Sources

1. Ludwig Von Mises, The Theory of Money and Credit, 1912.

Frequently Asked Questions about Balance of Payments

The Balance of Payments (BOP) is a statement recording all the financial transactions made between the residents of a country and the rest of the world over a certain period. It summarises a nation’s economic transactions, such as exports and imports of goods, services, and financial assets, along with transfer payments with the rest of the world. The Balance of Payments has three components: the current account, the capital account, and the financial account.

 The components of the balance of payments are often also referred to as the different types of balance of payments. They are the current account, the capital account, and the financial account. 


The current account provides an indication of the country’s economic activity. It indicates whether the country is in a surplus or deficit. The basic four components of the current are goods, services, current transfers, and incomes. The current account measures the country’s net income over a certain period.



The capital account measures the change in national ownership of assets and liabilities over a period. The account calculates the country’s inflow and outflow of public and private international investments. It is the sum of the country’s Foreign Direct Investment (FDI), foreign security investments and bank deposits, and the country’s reserve account. Capital accounts indicate the country’s economic health and future stability.



The financial account shows the monetary movements into and out of the country. While a positive figure represents an inflow, a negative figure indicates an outflow. In the case of a net flow, the amount is paid back either by borrowing from banks or international organisations or by withdrawing and using reserves.

Balance of Payments = Current Account + Financial Account + Capital Account + Balancing Item.

Final Balance of Payments Quiz

Question

Name the four basic components of the current account.

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Answer

Trade-in goods, trade-in services, primary income, and secondary income.

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Question

Under which part of the current account does the remittance fall?

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Answer

Secondary income

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Define financial accounts.

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Answer

Financial accounts are the records of financial transactions across countries between its residents and non-residents. The financial transactions result in a change of ownership of financial assets or liabilities.

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Question

State the three components of financial accounts.

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Answer

Long-term direct investments, long-term portfolio investments, and short-term ‘hot-money’ capital flows. 

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Question

 ______________________ involve the acquisition of different physical assets in other countries. 

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Answer

Long-term direct investments

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_________________ involve the purchase of securities issued by foreign governments or shares from companies abroad.


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Answer

Long-term portfolio investments

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Question

What are capital accounts?


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Answer

It is the part of the Balance of Payments that records all international transactions of the country. They also help in understanding the country’s relative level of economic stability or future stability and identify whether the country is a net importer or exporter. 

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What does the Balance of Payments show?

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Answer

The Balance of Payments (BOP) is a statement recording all the financial transactions made between the residents of a country and the rest of the world over a certain period.

Show question

Question

What are the three components of the BOP?

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Answer

Current account

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Question

Define debt forgiveness.

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Answer

Debt forgiveness refers to when a country cancels or reduces the amount of debt it has to pay.

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Question

What is it called when the BOP records a deficit or surplus?

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Answer

Balancing item.

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Question

What does the UK's current account run?

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Answer

Surplus

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What does the UK's financial account run?

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Answer

Surplus

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Question

What are some causes of a current account deficit?

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Answer

High inflation

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Question

Explain how the UK's uncompetitive exports causes a current account deficit.

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Answer

The UK struggles to compete with other price competitive goods from other countries. This results in less demand for UK exports, so less exports are sold leading to a deficit in the balance of trade.

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Question

Explain how high inflation in the UK causes a current account deficit.

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Answer

Higher inflation in the UK will result in UK exports becoming less competitive. Less UK exports are demanded and sold, causing a deficit in the balance of trade.

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Question

Explain how a depreciation of the GBP (pound sterling) causes the UK to record a current account surplus.

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Answer

A depreciation of the pound leads to more expensive imports and more competitive exports. UK exports are more competitive so it will be in high demand and will export more. This will record a surplus in the balance of trade.

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Question

What is 'hot money'?

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Answer

‘Hot-money’ are speculative capital flows that are transferred between different economies to take advantage of the overvalued or undervalued exchange rates.

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Question

Explain how 'hot money' inflows arise in the UK.

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Answer

When the Bank of England raises interest rates, consumers and businesses save more because they get a higher return on their savings. Foreign investors take advantage of that and save their money in UK banks. This increases the demand for the pounds and results in an appreciation of the value of the pounds.

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Question

What is the formula for calculating the current account balance?

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Answer

Current Account Balance = ( X − M ) + ( NY + NCT )


X = Exports of goods and services

M = Imports of goods and services

NY = Net income from abroad

NCT = Net current transfers


Show question

Question

Define current account.

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Answer

The current account is the record of a country’s sum of net trade (export minus imports), the net income flows, and net current transfers.

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Question

Define productivity.

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Answer

Productivity is the output produced per input. 

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Question

Define current account.

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Answer

The current account is the record of a country’s sum of net trade (export - imports), the net income flows, and net current transfers. 

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Question

The current account indicates the country’s ___________. 


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Answer

economic activity.

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Question

What does the current account record?

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Answer

It records the transactions of a country's trade, payments to foreign investors and other monetary transfers. 

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What are the two possible statuses of a current account?

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Answer

Current account deficit, and current account surplus.

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What are trade-in goods?

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Answer

It refers to the trade of tangible goods.  

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What are trade-in services?

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Trade-in services refer to the trade of intangibles such as tourism, banking, shipping, and likewise.  

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What is included under the primary income?

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Answer

Payments like wages, investment incomes, etc. are recorded under this component. 

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What is recorded under the secondary income?

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Answer

Government transactions, such as payments to the European Union (EU) or United Nations (UN), are recorded under this component. Additionally, remittance transfers from foreign workers, which is a one-sided transaction, are also recorded here. 

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Define remittance.

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Answer

The remittance, commonly known as international money transfer, is the money sent by migrant workers, usually to their families in their native countries.


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What is the formula for the calculation of a current account?


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Answer

Current Account Balance = (X - M) + (NY + NCT)

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Question

How does high inflation cause a current account deficit?

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Answer

If inflation rises at a faster rate than competitors, it will result in less competitive exports. Fewer volumes of exports will be demanded and sold, and imports are cheaper to buy, thereby deteriorating the country’s current account.  

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How can economic growth result in a current account deficit?

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Answer

During periods of economic growth, consumers spend more money and the demand for goods and services increase. If domestic firms can't keep up with the rising demand, the goods and services will have to be imported from other countries. 

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Question

How does overvalued currency affect the import volume?


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Answer

When the currency is overvalued, imports become cheaper. This allows higher volumes of imports. 

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Question

Define net capital flow.


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Answer

Net capital flow is the difference between the inward and outward flow of capital. 

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Question

Define securities.

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Answer

Securities are financial instruments that have a monetary value and can be interchanged with another asset or good of the same type. 

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What is hot money?

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Answer

‘Hot-money’ refers to the money that moves between financial markets to avail maximum capital gain

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Question

Investors move their money out of countries with _______ exchange rate, and into countries with _____ exchange rate

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Answer

lower, higher

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What does the capital account record?

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Answer

It mainly records the transfers of immigrants and emigrants and other government transfers such as debt forgiveness.

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What are the two types of direct investments?

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Answer

Inward and outward direct investments.

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Question

Purchasing a country's securities is a ______ investment.

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Answer

long-term portfolio

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Question

When a foreign MNC invests in the country, it is known as __________.

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Answer

inward direct investment

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Question

FDIs acquired in the form of mergers and takeovers, or acquisitions are examples of ____________. 


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outward direct investments

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Question

Current account = Balance in trade + __________ + ___________ + Net current transfers

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Answer

Current Account = Balance in trade + Balance in services + Net income flows + Net current transfers

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Question

_________ records the net investments from abroad. 

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Answer

Direct investment

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________  records financial flows such as the purchasing of bonds.  

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Answer

Portfolio investment

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Question

Other investments records _____________.

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Answer

other financial investments such as loans.


Show question

Question

What is the relationship between the balance of payments and goods and services? 

Show answer

Answer

The BOP records all the trades of goods and services conducted both by the public and private sectors, to determine the amount of money flowing into and out of the country.  

Show question

Question

If the country is able to export more goods and services than it imports, this means that the country is experiencing a  ___________.

Show answer

Answer

surplus

Show question

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