Definition: A Balance of Payments (BOP) is a report that states how money is flowing in and out of a given country. In other words, it is a statement that describes a country’s transactions with the rest of the world.
What Does Balance of Payments Mean?
The Balance of Payments report shows the current status of one country transactions with the rest of the world. The Balance of Payments is mainly divided in three accounts: the Current Account, the Capital Account and the Financial Account. The current account deals with economic input associated with the sale of goods and services (trough exports) plus income coming in; and economic output coming from the purchase of goods or services outside the country (trough imports) plus income paid to outsiders. The net result between inputs and outputs is called trade balance. A positive trade balance means exports are higher than imports and a deficit means the opposite.
On the other hand, the capital account deals with transfers of ownership of different type of assets (mostly physicals, as land or machinery) and other non-productive transfers of rights or assets that are not related to a current ongoing productive activity. Finally, the financial account deals with the flow of financial assets; this means, changes in ownership of domestic and foreign financial assets. The Balance of Payments is recorded according to standard bookkeeping procedures but in practice is rarely balanced, since the complexity of the transactions involved often create a disparity between the accounts. This disparity is normally transferred to the country’s financial reserves either if it is a positive or a negative difference.
Here’s a practical illustration of how a Balance of Payments work.
Example
Suppose Country X and Country Y are trading between them. Country X produces milk and Country Y produces Iron. Country X bought $1,500 worth of iron from Country Y and Country Y bought $300 of milk from Country X. Country Y also invested $5,000 buying land in Country X and Country X bought $3,000 of stocks from a company based in Country Y.
According to our previous definitions, here’s how both countries’ balances should look like:
Country X
Current Account ($300-$1,500) = -$1,200
Capital Account = $5,000
Financial Account= -$3,000
BOP Surplus = $800
Country Y
Current Account ($1,500-$300) = $1,200
Capital Account = -$5,000
Financial Account= $3,000
BOP Deficit = -$800
