Components of the Balance of Payments and their Interdependence

Components of the Balance of Payments (AO2)

The balance of payments is categorized into 3 main accounts:

• Current Account: A record of trade and income flows across countries. Essentially, it is exports (X) - imports (M). It has 4 components:

  • • Balance of trade in goods: Imports and exports of physical goods (cars, computers, etc.)

    • Balance of trade in services: Imports and exports of services (consulting, tourism, etc.)

    • Net income: Money flowing in and out of the economy as part of people's incomes

    • Current transfers: Money transfers as part of programs such as international aid
      
      

• Capital Account: A record of capital inflows and outflows across countries. This includes:

  • • Capital transfers: The movement of money as a result of debt forgiveness or people moving countries.

    • Rights: Includes intellectual property rights, land rights, etc.
      
      

• Financial Account: Investments abroad. This includes:

  • • Foreign Direct Investment (FDI): Investment into capital abroad done by international companies.

    • Portfolio investment: Trading of international investment assets, such as stocks and bonds.

    • Reserve assets: Stockpiles of currency and other investments held by the central bank. 

    • Official borrowing: Government borrowing from other countries' governments or institutions.

Interdependence Between the Accounts (AO2)

In the long term, countries should not be able to run deficits, as countries can only spend as much as they earn (in theory). This means 3 things:

• The 3 accounts should balance each other out and equal 0

  • • Current Account = Capital Account + Financial Account

• Credit items should be matched by debit items

• Deficits should be matched by surpluses

Calculations (AO4)

Given a set of data, you are expected to calculate the value elements of the balance of payments. The hardest part here is to identify which categories belong to which account - here is an example: