Balance of PaymentsIncluding Formula & How to Calculate

Written By:
Lisa Borga

What is the Balance of Payments (BOP)?

The balance of payments (BOP) provides a summary of all the economic transactions which a given country’s economy has made with the rest of the world over a specified period of time.

This includes all of the imports and exports of goods, services, and funds that have entered or left the economy.

This is a critical indicator for a country’s economy that shows how resources flow between itself and its trading partners.

The Formula for the Balance of Payments

The formula for BOP is:

CA + CFA = 0

Where:

CA = Current Account

CFA = Capital and Financial Account

This is because, for every transaction that is recorded as a credit or debit in either CA or CFA, it will be offset by an opposite transaction recorded in the other account.

In order to calculate an economy’s BOP, any surplus or deficit in the CA and CFA will be added together to reach zero or the total balance of payments.

The Balance of Payments Explained

BOP captures all transactions that occur between those within an economy, such as individuals, firms, organizations, and governments, and the rest of the world for a specified period of time, such as a year.

This includes all of the imports and exports of goods and services as well as government transfers such as foreign aid payments.

The balance of payments is composed of two distinct categories or accounts, the current account (CA) and the capital financial account (CFA).

This is a double-entry system in which all transactions within an account will involve both a debit or a credit to one account, which must be offset by an opposite and equivalent change in the other if all transactions are included.

CA includes all of a country’s net transactions of goods and services, current earnings on financial investments, and net transfer payments included for the given period.

This account may result in a surplus of income for the period if net exports exceed imports or a deficit if the opposite is true.

When goods, services, or transfers exit the country, this will be recorded as a debit in the current account, and when it enters, this will be recorded as a credit.

CFA includes all of a country’s changes in ownership of assets and liabilities.

This includes examples such as the transfer of ownership of financial derivatives, reserve assets, portfolio investments, capital transfers, and all other changes in ownership of assets and liabilities.

For example, if a country were to export a good, this would be a transaction recorded as a current account, and in return, it would receive foreign capital, which would be recorded as a transaction in the capital account.

Through this double entry mechanism, all transactions in BOP can be recorded and, when totaled, will always zero out.

This is because the total of all debit transactions will be equal to the total of all credit transactions.

Notably, though when looked at broadly, BOP must always become zero when added up, in practice, it may not appear this way due to measurement errors.

This is due to the difficulty in recording every transaction that has occurred on such a large scale and in translating between different currencies.

Historical Development of BOP

Until the 19^th century, there was relatively little international trade and what did occur was generally highly regulated.

Correspondingly transactions would generally be performed through valuable metals, which generally limited the degree to which a trade deficit could occur.

This meant that economic growth was low, and few crises occurred.

As a result, during this period, relatively little attention was paid to BOP.

However, during the 19^th-century, most countries, such as the U.S., abandoned the gold standard during the Great Depression.

This was coupled with many countries’ attempts to devalue their currencies.

As a result, many BOP crises occurred during this period.

In 1944, the Bretton Woods agreement attempted to prevent these problems by creating fixed exchange rates against the dollar, which would alone be convertible into gold.

However, trade imbalances and a loss of trust in the ability of the U.S. to be able to provide gold for all claims by dollar holders led to increasing demand by holders to convert their dollars.

This led to the abandonment of the Bretton Woods system.

Since this period, currencies have generally been allowed to float with few controls allowing the market to determine exchange rates.

In the wake of the Bretton Woods system, a greater number of BOP crises would occur, particularly among developing economies.

The Importance of BOP

BOP plays a critical role in addition to international investment position in economic policymaking.

One example of this is that BOP can serve as one indicator in determining the value of a country’s currency.

It also is a strong indicator of whether or not a country may be a suitable trade partner.

For example, if a country is currently facing an extreme imbalance in its BOP, such as a high deficit in its current account, it may be less willing to accept imports in the near future.

With such a deficit in its current account, a country could also indicate to its government policymakers that it must address the root causes of its lack of ability to compete internationally.

Example of BOP

For an example of BOP, consider Country X, which purchased 50 cars from its neighboring country.

Country X records the purchase of these cars as a credit to its current account, and its neighbor will record this transaction as a debit.

Components of BOP

The BOP is composed of two distinct accounts.

These include the current account and the capital and financial account.

These two accounts will balance each other out when they are added together.

Key Takeaways

• There are two categories within BOP the current account (CA) and the capital and financial account (CFA).
• CA records all international transactions that do not create any liabilities, including net transfers of goods and services.
• CFA records all transactions that do create liabilities which includes international transfers of financial assets.
• All surpluses or deficits that occur in one account of the balance of payments should be offset by an opposite change in the other account.