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The Balance of Payments Definition
The balance of payments refers to a statement of all the transactions carried out between the entities in one country and those in the rest of the world over a specific period.
A Little More on What is Balance of Payments (BOP)
The BOP is used to summarize all transactions that the entities in a country complete with those outside the country. The entities could be individuals, companies and government bodies. The BOP is also used to mean the balance of international payments. These transactions are made up of imports and exports of capital, goods and services and even transfer payments such as remittances and foreign aid.
What constitutes a company’s international accounts is its BOP together with its net international investment position. The BOP divides transactions into two accounts which are the current account and the capital account. The current account is made up of transactions in goods, services, investment income as well as current transfers.
The capital account when broadly defined is made up of transactions in financial instruments and central bank reserves. When defined narrowly, it includes only financial instrument transactions. The current account is used in the calculation of the national output while the capital account is not.
When the capital account is defined broadly, the summation of all the recorded transactions in the balance of payments must equal zero. This is because every credit that appears in the current account has a corresponding debit in the capital account. When a country exports a commodity, it obtains foreign capital when the commodity is paid for.
A country may turn to reserves if it is not able to fund its imports through exports of capital. Such a situation is known as a balance of payment deficit, and it involves using the capital account’s narrow definition which excludes the central bank reserves. When broadly defined, the balance of payments by definition ads up to zero. There is difficulty in calculating every single transaction between a country and the rest of the world and these leads to statistical discrepancies.
Data obtained from the balance of payments and international investment position is essential in the formulation of national and international economic policies. Some issues of these data such as payment imbalances and foreign direct investment are vital and need to be addressed by a country’s policymakers.
In order to impact the balance of payments, economic policies are aimed at specific objectives. For example, a country might decide to adopt a strategy designed to attract foreign investment in a particular sector. Eventually, the impact of this policy is captured in the balance of payment data.
While the current and capital accounts in a nation’s balance of payment sum to zero, sometimes imbalances appear between the current accounts of different countries. In 2016, the US had the most significant current account deficit at $481.2 billion according to the World Bank. Imbalances like those can give rise to tensions between the countries involved. In order to offset these deficits, the rest of the world is supposed to borrow and spend without equal abandon.
International transactions were denominated in gold before the 19th century and this provided little flexibility for the countries experiencing deficits in trade. Stimulating the trade surplus was the only way a nation could strengthen its financial position since growth was low. But because there was no efficient integration of national economies, steep trade imbalances rarely provoked crises. The integration of international economies later increased brought about by the industrial revolution.
Countries started to abandon the gold standard and engage in the competitive devaluation of their currencies due to the great depression. However, a system by Bretton Woods, which was in use from world war two until the 1970s, introduced a new gold-convertible dollar with fixed exchange rates to other currencies.
The US trade deficit deepened as its money supply increased until it reached a point that the government was unable to fully redeem foreign central bank dollar reserves for gold thus abandoning the system.
Since the end of the dollar’s convertibility to gold (Nixon shock), currencies have been floating freely. A country experiencing a trade deficit can therefore artificially depress its currency to make its products more attractive and thus increase its exports. A balance of payment crises can sometimes occur because of the increased mobility of capital across borders. When this happens sharp currency devaluations arise such as those that faced in Southeast Asia in 1998.
A surplus or deficit in a balance of payment can be shown in any of its three component accounts which are:
- A current account which covers the export and import of goods and services
- A capital account which covers investment inflows and outflows
- A gold account which covers the gold inflows and outflows.
The accounting of the balance of payments highlights the competitive strengths and weaknesses of a country, and it helps in achieving a balanced economic-growth.
References for Balance of Payment
Academic Research on Balance of Payment
- Balance of payment crises in emerging markets: how early were the ‘early’warning signals?, Bussiere, M. (2013). Applied Economics, 45(12), 1601-1623. This paper examines how the timing of the crisis has been receiving little attention even though many articles have already proposed empirical models of currency crises. The paper attempts to fill this gap through the consideration of discrete dynamic choice models.
- Controversial and novel features of the Eurozone crisis as a balance of payment crisis, Cesaratto, S. (2013). In Post-Keynesian Views of the Crisis and its Remedies (pp. 123-141). Routledge. This article examines various explanations given for the nature of the balance of payments disequilibrium of the Eurozone members with the presumption of German mercantilism.
- The exchange rate, the balance of payments and monetary and fiscal policy under a regime of controlled floating, Mussa, M. (1976). The Scandinavian Journal of Economics, 229-248. This paper provides a consideration of the extension of the fundamental principles of the monetary approach to the analysis of the balance of payments to a regime of floating exchange rates with active intervention by the authorities to control rate movements.
- The twin crises: the causes of banking and balance-of-payments problems, Kaminsky, G. L., & Reinhart, C. M. (1999). American economic review, 89(3), 473-500. Nowadays the subject of a financial crisis is at the top of academic and policy discussions, and because of this, the paper attempts to analyze the existing links between banking and the currency crises.
- The monetary approach to balance-of-payments theory, Johnson, H. G. (1972). Journal of financial and quantitative analysis, 7(2), 1555-1572. This paper provides a new way of approaching the theory of the balance of payments and balance of payments adjustment that has been emerging lately in several places.
- The monetary approach to the balance of payments: A nontechnical guide, Johnson, H. G. (1977). Journal of international economics, 7(3), 251-268. This study focuses on the monetary approach which uses monetary instead of multiplier and market stability tools.
- Price behavior in the light of balance of payments theories, Kravis, I. B., & Lipsey, R. E. (1978). Journal of International Economics, 8(2), 193-246. This article studies the price predictions of the elasticity and monetary theories of balance of payments adjustments which are in comparison with the actual price behavior.
- A long term model of oil markets, economic growth and balance of payment constraints, Manne, A. S., & Rutherford, T. F. (1991). In Applied General Equilibrium (pp. 51-69). Physica-Verlag HD. This article studies and describes a long term model of the constraints plaguing oil markets, economic growth, and balance of payments.
- An empirical investigation on the sustainability of balancing item of balance of payment accounts for OIC member countries, Tang, T. C., & Lau, E. (2009). Journal of Economic Cooperation and Development, 30(1), 1-16. This is an examination of the sustainability of the balancing item of the balance of payment accounts for OIC member countries.
- Portfolio equilibrium and the balance of payments: A monetary approach, Frenkel, J. A., & Rodriguez, C. A. (1975). The American Economic Review, 65(4), 674-688. This paper identifies the incentives generated by the Bretton Woods II system that may have played a part in the subprime liquidity crisis which is spreading through the international monetary system.
- Price behavior in the light of balance of payments theories, Kravis, I. B., & Lipsey, R. E. (1978). Journal of International Economics, 8(2), 193-246. This article compares the actual price behavior with the price predictions of the elasticity and monetary theories of balance of payments adjustment.