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Balance of Payments: Concepts, Components, and Importance

IndianMoney.com Research Team | Posted On Saturday, December 07,2019, 03:49 PM

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Balance of Payments: Concepts, Components, and Importance

 

 

What is the balance of payments (BOP)?

Balance of payments can be defined as the record of all monetary transactions made between the residents of a country with other countries within a specific period. Transactions made by companies, individuals and the government are contained in the balance of payment statements. These are official records that help analysts monitor the flow of funds and supervise economic policies accordingly. Balance of payments plays a vital role in determining the inflows and outflows of cash in the economy. When all the elements of BOP are added up it sums up to zero, in a perfect scenario where the inflows and outflows of cash are balanced. However, in most cases, this does not happen.

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Balance of payments formula:

The balance of payment is calculated using the following method:

Current account balance + capital account balance + reserve balance = balance of payment

(X-M) + (CI – CO) + FOREX = BOP

Here, X stands for exports, M stands for imports, CI is the acronym for capital inflows, CO is capital flows and FOREX is the foreign exchange reserve balance.

Importance of balance of payment:

The balance of payment provides important data that records the inward and outward flow of cash within an economy. This data is vital in monitoring the flow of funds to develop an economy. Some of the reasons why BOP is important for an economy are as follows:

  • It gives a picture of the financial and economic health of the country. It is used to understand the economic relations of different countries and is thus considered a vital part of international financial management.
  • The balances of payments are issued in the form of statements in a quarterly manner. These statements are used to determine the performance of the currency and whether its value has appreciated or depreciated. Thus the BOP statements give a clear idea of how a country currency is performing in comparison to other currencies.
  • The government uses the BOP statements to understand the economic trends and devise efficient fiscal and trade policies.
  • Economists and analysts use this information to understand the economic dealings of the country with a foreign nation. It helps them take appropriate measures in case certain economic trends harm country’s economy. 
  • Also, the BOP allows evaluating the potential of a country as a constructive economic partner. It indicates whether or not a country contributes to international economic growth. 

Types of balance of payment:

Balance of payment can be referred to the difference between exports minus imports. While computing for the balance of payment you have to include the balance of trade as a vital part. It is further divided into two categories which are as follows:

Favourable balance of payment:

A favourable balance of payment is a scenario where the goods and services exported plus capital transfers are in excess when compared the amount of goods and services imported and capital transfers abroad.

Unfavourable balance of payment:

An unfavourable balance of payments is the result of excessive goods and service imported plus capital transfers from abroad over the goods and services and services exported plus the capital transfers from abroad.

Components of Balance of Payments:

The three components of the balance of payment are listed below. The total of the current account is required to balance the sum of financial and capital accounts in an ideal economy. However, it does not happen and in most cases, the balance of payments indicates a deficit or surplus of funds.

Current account:

The current account records and monitors the inflows and outflows of funds from the goods and services trade. Such accounts include records of funds receive and spent on activities like tourism, Revenue from the service sector, manufacture of goods and transportation of raw materials etc. the revenue generated from stocks and royalties from patents and copyrights are also recorded under the current account.

Capital account:

Cash flows from international capital transactions are recorded and monitored by the country’s capital account. These are the transaction that takes place through the purchase or disposal of non-financial and non-produced assets. Funds received from gift taxes and debt forgiveness is also recorded in the capital account.

Financial account:

Under the financial account the flow of funds from businesses, real estate, stocks, gold and government-owned assets are monitored. Financial account also maintains the records of assets owned by foreign nationals in India, foreign investments and assets owned by Indian nationals abroad.

See Also: Bharat Bill Payment System

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