Balance of Payment (BOP)
Balance of payments refers to the sum of all economic transactions between residents of the reporting country and residents of foreign countries during a specified period. All individuals, businesses, and government agencies are considered residents. A standard double-entry bookkeeping method is used to maintain the balance of payments record. Credits and debits are recorded for international transactions.
Imports, exports, and transfer payments, including foreign aid and remittances, are included in these transactions. As part of the complex mechanism of development, making sure the citizens are able to attain social and economic welfare, creating economic stability, and maintaining employment, these transactions play an important role.
Features of Balance of Payments (BOP)
a) The BOP is the systematic record of a country’s receipts and payments with other countries.
b) This is a statement of accounts for a particular period of time, usually a year.
c) In addition to visible, invisible, and capital transfers, BOP includes all three items. As a result, it provides a comprehensive assessment of a country’s situation.
d) A double entry system is used to record receipts and payments. As a result debit and credit sides of accounts are automatically kept in balance.
e) There needs to be an adjustment if the total receipts and payments differ.
f) Government and non-government receipts and payments are included in the BOP.
Balance of Payment Formula
Current account + Capital account + Financial account + Balancing Item = 0
Types of Balance of Payment
- Favorable Balance of Payment
- Unfavorable Balance of Payment
Components of Balance of Payment
The balance of payments measures a country’s income, trade, assets, and transactions among three essential components. An economist evaluates a nation’s economic and financial standing in international markets based on its current account, financial account, and capital account:
A) Current Account
A scan of goods and services entering and leaving a country is conducted by this account. A raw materials account covers all payments for construction materials and goods. Additionally, delivery of goods and services from tourism, engineering, stocks, business services, transportation, and royalties from licenses and copyrights are included in this category. All of these factors contribute to a country’s BOP.The current account measures a nation’s trade balance, direct payments, and net income in order to determine its economic standing. These funds come from purchases made by citizens, and these funds provide the country with savings and income for purchases, business activities, and infrastructure investments.
Current account balances occur when consumer spending covers these activities.Current account deficits mean a nation’s citizens spend more money on imports than they save. It is possible for a nation to borrow money from another to fund a current account deficit. The economic growth of a deficit country may slow over time if it is unable to pay off its debts.
Current Account Formula
Current Account = Balance in trade + Balance in services + Net income flows + Net current transfers
Balance of Payment on Current Account = Visible + Invisible Exports – Visible + Invisible Imports
Components of Current Account
- Exports and Imports of Visible Items or Goods
- Invisible Items or Non-material Goods or Services
- Transportation and Travelling Services
- Services of the Experts
- Investment Income and Expenses
- Donation and Gifts
- Services Rendered by Commercial Undertakings
- Government Transactions
B) Capital Account
A capital account monitors the purchase and sale of assets (non-financial) such as lands and properties. Immigrants who move into different countries also record the flow of taxes, acquisition, and sale of fixed assets. Capital account finance determines the shortage or excess in the current account.In a balance of payments, the capital account represents all the financial processes that do not affect an economy’s production, income, or savings.
The capital account records all transactions undertaken by a nation, such as the transfer of copyrights or trademarks or cross-border payments on insurance premiums. A nation’s capital account can be rare because most economic and financial activities have a direct impact on income, savings, and production.
Components of Capital Account
- Gold Movement
- Reserve, Monetary Gold and SDR:
- Movement in Banking Capital
- Private Foreign Loan Flow
- Official Capital Transactions
C) Finance Account
This account records funds that flow to and from other countries through investments such as real estate, foreign direct investments, and business enterprises. It analyses whether it is acquiring or selling more assets like stocks, gold, equity, etc., by calculating the foreign proprietor of domestic assets and the domestic proprietor of foreign assets.Changing ownership of foreign assets, as well as foreign ownership over a country’s own assets, is reflected in its financial account.
When the ownership of foreign assets by a country equals that of domestic assets by other nations, the financial account is in balance. The foreign ownership of a country can increase faster than its domestic ownership, resulting in a deficit. When a nation’s balance of payments shows a deficit, it means it sells more assets than it gains.
Importance of Balance of Payment (BOP)
In order to understand a nation’s financial and economic standing, the balance of payments and its components are crucial. A country’s currency value can also be viewed by this metric as appreciating or depreciating. The balance of payments is used by many financial professionals in roles such as investment management, government policy-making, and federal banking to develop policies and strategies that support a nation’s growth.
Here are a few more important uses of the balance of payments:
a) Decision Making
At the national level, the balance of payments is an extremely important metric for making decisions. Using data from a country’s balance of payments, economists, federal accountants, policymakers, and others determine how to adapt production and exportation to changing prices, interest rates, inflation rates, and employment levels.
b) Developing Trade Policies
The balance of payments provides insight into economic transactions between one country and another, which is why governments use it when developing trade policies. Using the balance of payments as a tool for analysis helps economists identify beneficial and harmful trends, enabling them to develop trade policies that support economies and help nations reach important goals.
c) Establishing Fiscal Objectives
A balance of payments analysis is also used by governments to set important objectives that lead to positive economic development for their nations. A country might strategize approaches for getting out of a deficit based on its balance of payments, for instance. Increasing production on a GDP in high demand, borrowing from another nation or even establishing trade agreements are some of these fiscal objectives. Economic and financial growth can be better understood when fiscal objectives are in place.
d) Implementing Growth Strategies
In order to accomplish fiscal objectives and ensure consistent economic growth, governments use the balance of payments to determine where to focus their efforts. By analyzing the balance of payments data, governments can develop strategies that support their nations’ growth and status abroad. To develop the most effective and beneficial growth strategies, it is also crucial to understand whether a nation is in deficit or surplus.
e) Analyzing Deficits
According to the balance of payments, a country becomes deficit or surplus depending on its financial situation. Economists can use the balance of payments data to better understand the reasons behind a nation’s deficit, and develop solutions. In addition, economists are able to better allocate domestic funds to get out of deficits by analyzing the balance of payments.
f) Investing with Surplus
Economists use the balance of payments to analyze deficits and invest surpluses. A nation can reinvest surpluses in its economy when it has surpluses in gross domestic products or other assets. The result can be an increase in the availability of jobs, resources, domestic goods and services, and other domestic assets. It may also be possible for countries with surpluses in their balances of payments to provide assistance to countries with deficits.
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