The Economic Concept of Balance of Payments

Introduction

This paper discusses the economic concept of balance of payments and how it impacts the economy of a nation. Firstly, the term is explained through its various components and then the implications of a negative balance of payments are explained.

Balance of Payments

The balance of payments (BOP) is the method of recording the payments and receipts of the residents of the country in their transactions with residents of other countries including the respective governments. If a country receives more money for the trade than it pays, an account surplus is created while if a country pays out more than it receives then an account deficit is created. In theoretical terms, the balance of payments should be zero, meaning that exactly the same amount of money is received as it is given out. However, in reality this hardly ever happens due to a variety of reasons. BOP is divided into three main categories explained below (Ison & Wall, 2008).

The Current Account

The current account is the calculation of the inflow and outflow of goods and services into a country. It includes the balance of trade of import/export through goods and services account and includes the earnings on investments, employee compensation, and current transfer through the income account (Heakal, 2008).

The Capital Account

The capital account contains all the capital transfers of a country. This means that records of purchase and sale of non-financial assets and non-produced assets are handled through this account (Heakal, 2008).

The Financial Account

The financial account records the flow of international money related to investment in business, stocks, bonds, real estate, and other short-term capital (Heakal, 2008).

Deficit Balance of Payments

A deficit in the balance of payments is described as a higher amount of purchases from another country than its sales to other countries. Countries having higher price levels, or higher gross national product, or higher interest rates, or better investment opportunities compared to other countries are more likely to have a balance of payment deficit (Stein, 2004).

A balance of payment deficit is seen as a sign of weakness as the deficit needs to be fulfilled by foreign loans or foreign investment which can mean that higher interest needs to be paid and also a higher amount of foreign involvement in the country. Therefore, governments try to control the balance of payments through the change in exchange rate following the Marshall-Lerner principle which states that the price elasticity of demand for imports and exports must be greater than unity for improvements to be affected in the balance of payments (Lerner, 1944). Also, governments use deflationary policies like increasing the interest and tax rates and curbing imports to reduce the balance of payments (Stein, 2004).

However, balance of payments is not always harmful. It simply means that a country is financing its deficit through the capital account which means foreign investment is increasing in the country which can boost the economy in times of recession (Stein, 2004).

Conclusion

Balance of payments is an important concept in the economics of a country and various components make up the balance of payments. The balance of payments cannot be zero as a deficit in the current account will be offset by a surplus in the capital account and vice versa. However, a deficit in the balance of payments is considered harmful for the economy as it means a lot of dependency on imported products and foreign investment in the country. While some might say a deficit can boost a country in times of recessions, it generally shows a lack of self-dependency and gross domestic product.