Balance of Payments
Balance of Payments
The balance of payments is an accounting statement that records transactions (trade in goods, services, and financial assets) between a country’s residents and the rest of the world. Those transactions consist of receipts and payments—credits (entries that bring foreign exchange into the country) and debits (entries that record a loss of foreign exchange), respectively—that are recorded through the use of double-entry bookkeeping. Balance-of-payments data usually are reported quarterly in national publications and also are published by the International Monetary Fund.
The balance of payments consists of the current account, the capital account, and the financial account (see the illustration). The current account includes trade in merchandise (raw materials and final goods), services (transportation, tourism, business services, and royalties), income (from salaries and direct, portfolio, and other types of investment), and current transfers (workers’ remittances, donations, grants, and aid). The current account is related to the national income accounts because the trade balance corresponds broadly to the net export value recorded in the national income accounts as one of the four components of the gross national product (GNP), along with consumption, investment, and government expenditures.
The capital account records all international capital transfers. Those transfers include the monetary flows associated with inheritances, migrants’ transfers, debt forgiveness, the transfer of funds received for the sale or acquisition of fixed assets, and the acquisition or disposal of intangible assets. The financial account records government-owned international reserve assets (foreign exchange reserves, gold, and special drawing rights with the International Monetary Fund), foreign direct investment, private sector assets held abroad, assets owned by foreigners, and international monetary flows associated with investment in business, real estate, bonds, and stocks.
The balance of payments should always be in equilibrium. The current account should balance with the sum of the capital and financial accounts. However, because in practice the transactions do not offset each other exactly as a result of statistical discrepancies, a separate line with those discrepancies is included in the statistical presentation.
If the current account is in equilibrium, the country will find its net creditor or debtor position unchanging because there will be no need for net financing. Equilibrium in the capital and financial accounts means no change in the capital held by foreign monetary agencies and reserve assets. In the case of disequilibrium arising when a country buys more goods than it sells (i.e., a current account deficit), the country must finance the difference through borrowing or sale of assets (i.e., there is an inflow of capital and thus a capital and financial account surplus). In other words, the country uses foreign savings to meet its consumption or investment needs. Similarly, if a country has a current account surplus, the capital and financial accounts record a net outflow, indicating that the country is a net creditor. The exchange rate regime is an important determinant of the adjustment toward the new equilibrium. With fixed exchange rates, central banks must finance the excess demand for or supply of foreign currency at the fixed exchange rate by running down or adding to their reserve assets. Under floating exchange rates, balance of payments equilibrium is restored by movements in the exchange rate.
A number of theories have been developed to explain the adjustment process of the balance of payments. In a world without capital flows the elasticities approach provides an analysis of how changes in the exchange rate affect the trade balance, depending on the elasticities of demand and supply for foreign exchange and/or goods. An exchange rate depreciation increases the domestic price of imports and lowers the foreign price of exports. However, depreciation reduces imports only if import demand is
|United States balance of payments, 1970-2005|
|(In millions of U.S. dollars)|
|SOURCE: Bureau of Economic Analysis, International Economics Accounts, U.S. Department of Commerce, http://www.bea.gov/international, Washington, D.C., 2006.|
|Exports of goods and services and income receipts||68,387||344,440||706,975||1,421,515||1,749,892|
|Exports of goods and services||56,640||271,834||535,233||1,070,597||1,275,245|
|Imports of goods and services and income payments||259,901||–333,774||–759,290||–1,778,020||–2,455,328|
|Imports of goods and services||–54,386||–291,241||–616,097||–1,448,156||–1,991,975|
|Unilateral current transfers, net||–6,156||–8,349||–26,654||–58,645||–86,072|
|U.S. Government grants||–4,449||–5,486||–10,359||–16,714||–31,362|
|U.S. Government pensions and other transfers||–611||–1,818||–3,224||–4,705||–6,303|
|Private remittances and other transfers||–1,096||–1,044||–13,070||–37,226||–48,407|
|Capital account transactions, net||—||—||–6,579||–1,010||–4,351|
|U.S.-owned assets abroad, net (increase/financial outflow (–))||–8,470||–85,815||–81,234||–560,523||–426,801|
|U.S. official reserve assets, net||3,348||–7,003||–2,158||–290||14,096|
|U.S. Government assets, other than official reserve assets, net||–1,589||–5,162||2,317||–941||5,539|
|U.S. private assets, net||–10,229||–73,651||–81,393||–559,292||–446,436|
|Foreign-owned assets in the U.S., net (increase/financial inflow (+))||–6,359||62,612||141,571||1,046,896||1,212,250|
|Foreign official assets in the United States, net||6,908||15,497||33,910||42,758||199,495|
|Other foreign assets in the United States, net||–550||47,115||107,661||1,004,138||1,012,755|
|Statistical discrepancy (Sum of above items reversed)||–219||20,886||25,211||–70,213||10,410|
elastic; the same is the case for the behavior of exports after a decline in export prices. Thus, the final impact on the current account balance depends on the elasticity of demand in each country for the other country’s goods and services.
The absorption approach emphasizes the way in which domestic spending on domestic goods changes relative to domestic output: The trade balance is viewed as the difference between what the economy produces and what it spends. In an economy that is operating below its full potential an exchange rate depreciation tends to increase net exports (given the elasticity conditions noted above) and bring about an increase in output and employment. In an economy operating at full potential, in contrast, a depreciation tends to increase net exports, but because it is not possible to increase output, the result is higher prices of domestically produced goods.
In the modern global economy with well-developed financial markets and large-scale capital flows, financial assets play an important role in the analysis of the balance of payments. The lifting of controls on the movement of capital and financial flows has been fundamental to promoting world trade and eventually greater incomes. The unrestricted movement of capital allows governments, businesses, and individuals to invest capital in other countries, thus promoting not only foreign direct investment but also portfolio investment in the capital market.
With perfect capital mobility, monetary and fiscal policies affect the balance of payments through the interest rate channel. Under fixed exchange rates an increase in the money supply will reduce interest rates and lead to capital outflows, tending to cause a depreciation that will have to be offset by sales of foreign exchange by the central bank. This will then reduce money supply until it reaches its original level. Thus, monetary policy is ineffective in increasing output. Fiscal policy, however, is highly effective because a fiscal expansion tends to raise interest rates, leading the central bank to increase the money supply to support the exchange rate, reinforcing the impact of the expansionary fiscal policy. Under floating exchange rates, monetary policy is highly effective and fiscal policy is ineffective in changing output. A monetary expansion leads to depreciation and higher exports and output. Fiscal expansion, in contrast, causes an appreciation of the exchange rate and crowds out net exports.
The introduction of interactions between prices and changes in the exchange rate leads to a model that postulates that price flexibility ultimately moves an economy to full employment. The mechanism involves changes in the domestic money supply that take place as the central bank keeps selling foreign exchange to domestic residents in exchange for domestic currency. A monetary contraction thus reduces prices, improves competitiveness, and increases net exports and employment. Under floating exchange rates, in the short run a monetary expansion increases output and reduces interest rates, causing a depreciation of the exchange rate. In the long run, however, a monetary expansion increases the price level and the exchange rate, keeping real balances and the terms of trade unchanged.
The monetary approach to the balance of payments postulates that disequilibrium in the balance of payments is essentially a monetary phenomenon. It emphasizes the central banks’ balance sheet identity—a change in net foreign assets equals the difference between changes in high-powered money and in domestic credit—which shows that sufficient contraction of domestic credit will improve the balance of payments. This improvement comes about through higher interest rates and lower domestic income and employment. Finally, the asset market (or portfolio) approach incorporates assets besides money. In recognition of the fact that asset markets across countries are well integrated, changes in the demand for and supply of assets will affect interest rates, exchange rates, and the balance of payments.
Maintaining a favorable balance-of-payments position is important for macroeconomic stability, and countries gear their policies toward achieving that goal. Although current account deficits that are financed through non-debt-creating capital flows may not pose an immediate threat, large and unsustainable deficits can transform into chronically unfavorable balance-of-payments positions that may affect the stability of the currency. Correcting such unfavorable positions is done through the adoption of stabilization programs that sometimes are supported by the International Monetary Fund through the provision of short-term financing to ease the burden of temporary problems.
SEE ALSO Balance of Trade; Capital Controls; Capital Flight; Equilibrium in Economics; Exchange Rates; Exports; Imports; Interest Rates; International Monetary Fund; Mundell-Fleming Model; Policy, Fiscal; Policy, Monetary; Reserves, Foreign; Trade Deficit; Trade Surplus
Dornbusch, Rudiger, Stanley Fischer, and Richard Startz. 2004. Macroeconomics, 8th ed. Boston: McGraw-Hill.
Frenkel, Jakob, and Harry G. Johnson, eds. 1976. The Monetary Approach to the Balance of Payments. Toronto: University of Toronto Press.
Husted, Steven, and Michael Melvin. 2007. International Economics, 7th ed. Boston: Pearson/Addison-Wesley.
International Monetary Fund. Various years. Balance of Payments Statistics Yearbook. Washington, DC: Author.
Balance of Payments
Balance of Payments
What It Means
The balance of payments (sometimes referred to as BOP) is a financial statement that summarizes a country’s international economic purchases and sales in a given period of time. It is expressed in financial terms and shows all of the international money movements, called flows, in and out of a country in a certain time period. These money flows can be generated by exported goods, imported goods, international investments, and other sources.
Countries use balance-of-payments accounting to keep track of their payments to other countries as well as their receipts from other countries. In a balance-of-payments account record, any transaction that is the result of a payment to another country is entered as a debit and given a negative sign. Any transaction that is the result of a receipt from another country is entered as a credit and given a positive sign.
The balance of payments is sometimes used, along with other reports and economic indicators, to determine how economically and politically stable a country is. If the balance of payments is negative for a given period, it indicates that more money is flowing out of a country than flowing in. Likewise, if it is positive, it means that more money is flowing in than out.
When Did It Begin
The balance-of-payments accounting system developed with the increase in international trade that began some 500 years ago. In the sixteenth and seventeenth centuries commerce between nations escalated rapidly, enabled by advances in maritime shipping, communications, railway development, and the growth of centralized trading cities. The major trading nations, including England, France, and the United States, built their national wealth and power by exporting more manufactured goods than they imported. This meant that these countries were essentially selling more than they were purchasing, and the practice, known as mercantilism, allowed these and other countries to become enormously wealthy.
A relationship between the merchandise exported out of a country and the merchandise imported into the country is automatically established whenever a country is involved in international trade. This relationship between exports and imports is known as the balance of trade. As the early trading nations discovered, the balance of trade plays a crucial part in determining the balance of payments.
More Detailed Information
Balance-of-payments accounts are made up of two sections, the current account and the financial account (also called the capital account).
The current account shows the financial transactions of imported and exported goods and services. Automobiles, electronics, and chemicals are examples of merchandise that would be covered in this category. The import or export of services, such as banking, insurance, and other intangible products, would also be registered in the current account. Finally, any income from investments in foreign companies (which is known as investment income) must be registered in the current account. For example, if a U.S. citizen owns a share of a Polish company and receives a dividend payment of $15 (dividends are portions of profit that a company distributes to its investors), the payment appears on the U.S. current account as the receipt of $15 of investment income.
If a country imports more goods, services, and income than it exports, it has what is known as a current-account, trade, deficit. If the opposite is true, and exports of goods, services, and income exceed those of imports, the country has a current-account surplus. The balance-of-payments accounting for the United States has shown a steady trade deficit in recent years, the result of higher import amounts than export amounts.
The earnings and payments for internationally traded goods and services together make up a country’s balance of trade. The amounts registered in the current account are typically the bulk of all of those registered in the balance of payments.
The financial account shows the financial transactions involving the purchase or sale of assets (that is, the transfer of wealth, which includes investments, loans, and currencies). This means that if a foreign company buys stock in a U.S. company, the transaction appears on the U.S. balance of payments as a credit in the financial account, because capital (money) is coming into the United States with the stock purchase. If the U.S. company were to buy stock in the foreign company, capital would flow out of the United States, and the transaction would be registered in the financial account as a debit.
One important piece of economic information illustrated by the balance of payments is the value of a country’s total exports and that of its total imports. When the value of a country’s total imports is subtracted from the value of its total exports, the result is what is known as net exports. This figure shows how much more money foreign countries spend on a home country’s goods and services than the home country spends on foreign goods and services. For example, if, in a given year, other countries purchase $100 billion worth of U.S. exports and Americans purchase $75 billion worth of foreign imports, the net exports would be positive $25 billion.
Since the late 1950s the United States has increased the amount of money it invests in European corporations. It has also invested in the U.S. military’s presence abroad. These factors have contributed to unfavorable balances of payments, meaning that they show deficits instead of surpluses.
In the early 1970s the U.S. government attempted to improve the balance of payments by adjusting the exchange rate of the dollar downward in relation to the currencies of other countries. This action is known as devaluing the dollar, and it results in making the home country’s exports relatively less expensive for foreigners and foreign products relatively more expensive for consumers in the home country. Thus, the amount of imports decreased. This potentially could have improved the balance of payments, but oil-producing countries during this time increased the cost of petroleum. Because the United States is dependent on petroleum from these countries, Americans continued to purchase it, which negatively affected the balance of payments and counteracted any benefits resulting from the devaluation of the dollar.
In the early twenty-first century the dollar again experienced a significant decline in value. U.S. exports did see improvement as U.S. products became less expensive to foreign countries. At the same time, some Americans were concerned that the Chinese government had unfairly set the value of its own currency, the yuan, too low, reducing the price, and thus increasing the quantity, of Chinese goods sold in the United States.
Balance of Payments
BALANCE OF PAYMENTS
The balance of payments is similar to the balance sheets bookkeepers maintain to keep track of their companies' credits and debits. But it does not focus on the cash flow of a single company. The balance of payments records the credits and debits of the entire U.S. economy with its foreign trading partners. If U.S. consumers, businesses, or the government spend more in foreign economies than those economies spend in the United States, the balance of payments is "in deficit." If the reverse is true, the U.S. balance of payments is "in surplus."
The balance of payments is not the same as the balance of trade. The balance of trade is only one of two major components in the balance of payments. The first component is the "current account." The "current account" is roughly the same as the balance of trade, and includes all short-term imports and exports of goods and services. The second component is the "capital account", which includes long-term investments and loans between the United States and foreign economies.
Before 1933 the United States and most of the industrialized world was on the gold standard. Applying this standard meant that all international currencies were valued in terms of how much gold they represented. Because of the Great Depression, Great Britain abandoned the gold standard in the early 1930s, but it was not until the Bretton Woods Agreement of 1944 that a new system based on the U.S. dollar instead of gold was implemented. Under this system a country could always "devalue" its currency relative to other countries' currencies if its balance-of-payments deficit became dangerously large. This would wipe out much of the deficit. The United States was the only country that could not devalue its currency to lower its balance-of-payments deficit. That restriction was applied because the Bretton Woods system valued all currencies against the U.S. dollar. President Richard Nixon (1913–94) abandoned the Bretton Woods Agreement in 1973, which enabled the United States to devalue the dollar when necessary. Since then all world currencies including the dollar may be exchanged freely on the world market at whatever rate the market will bear. The United States continues to accumulate balance-ofpayment deficits, when the value of the dollar is strong compared to other currencies. Foreign goods and services are inexpensive relative to U.S. goods and services. The U.S. government offsets these deficits by selling U.S. government bonds to foreign investors attracted to the stable dollar.
See also: Bretton Woods Agreement, Gold Standard, Richard Nixon