What is Balance of Payment?
The balance of payment is an important concept in the study of commerce and economics. The balance of payment is discussed very briefly in Chapter 6 called Open economy macroeconomics of the NCERT book of Class 12, this chapter is prescribed by the Central Board of secondary education and it holds significant weightage in the board examination that is held by the CBSE.
The study material on Vedantu, on the topic balance of payments, explains the complex concepts in a simplified language. It explains in detail what a balance of payment is, what are the inflow and outflow of foreign currencies, the types of balance payment accounts, The importance of balance of payment. Other details about the balance of payments can be accessed by visiting Vedantu’s website, Vedantu gives a comprehensive understanding of the topic, the study material provided by Vedantu is a product of intensive research and planning, the study notes are up-to-date and contain all the minute details that are important for the understanding of a particular concept.
What is an Open Economy
An open economy is an economy that has a trading relationship with other nations in goods and services or financial assets. For example, Indians like to use products from foreign countries and therefore some of the production is also exported to other foreign countries therefore foreign trade is responsible for influencing Indian aggregate demand.
In an open economy, it is important to have a balance of payments as it records the transactions made in goods, services and also the assets between residents of a country with the rest of the world, the balance of payments records transactions for a specified time period which is typically a year. In simple words a bop can be defined as a record which contains a summary of all the transactions undertaken by the firms, government institutions, individuals of a country with the firms, government institutions, individuals of other foreign countries.There are three types of payment accounts in a balance of payment or BOP, That are – current account, capital account, and finance account. Transactions taken up by net trade in goods and services, net transfer payments, net earnings on cross border investment are all recorded in the current account. The capital account is responsible for recording the transactions of a nation’s financial instruments and central bank reserves. Finance account deals with all the transactions which include ownership change for foreign assets between a nation’s residents and non-residents.
Importance of Balance of Payment
The importance of Balance of Payment account can be gauged from the following pointers –A financial record such as the BOP analyzes all the transactions under any nation’s economy regarding goods and services’ exports and imports and other finances for a financial year.The BOP helps the government to identify the various sectors in its economy, which possess the potential for export-oriented growth.With the help of the BOP, the government can implement higher tariffs and tax rates on the inflow of foreign exchange to encourage domestic industries to become more self-sufficient and minimize non-essential items’ import.If a nation possesses a flourishing export trade, its BOP can provide the government with accurate details so that it can adopt measures like currency devaluation to let its goods and services be availed at affordable rates and thereby improve foreign exchange outflow exponentially.Another important reason why a BOP account is essential for an economy is that it is a major indicator for a government to formulate its standards on monetary and fiscal policies, control of inflation, etc. Students can gain a more in-depth idea about Balance of Payment with study materials provided by Vedantu online. Check out available study material and online classes today for better exam preparations.
Key Components that are studied in Relation to the Balance of Payments-
BoP Surplus and Deficit
The Foreign Exchange Market
Determination of the Exchange Rate
Flexible Exchange Rates
Fixed Exchange Rates
Managed Floating
The determination of income in an Open Economy
National Income Identity for an Open Economy
Equilibrium Output and the Trade Balance
Trade Deficits, Savings And Investment
FAQs on Understanding the Balance of Payment
1. What is the Balance of Payments (BoP) in simple terms?
The Balance of Payments (BoP) is a systematic record of all economic transactions between the residents of a country and the rest of the world during a specific period, usually a year. Think of it as a country's financial statement that shows whether it is a net lender to or a net borrower from other countries.
2. What are the main components of the Balance of Payments?
The Balance of Payments is primarily divided into two main accounts:
- Current Account: This records the trade of goods (exports and imports), services (like tourism and software services), and transfer payments (like gifts and remittances).
- Capital Account: This records all international transactions of assets. It includes foreign direct investment (FDI), portfolio investment, and loans and borrowings.
There is also a component for Errors and Omissions to ensure the accounts balance.
3. Can you explain the difference between a BoP surplus and a BoP deficit?
A BoP surplus occurs when a country's total credits (inflows of foreign currency) are greater than its total debits (outflows of foreign currency). This means the country is receiving more money than it is sending out. Conversely, a BoP deficit happens when total debits exceed total credits, indicating that the country is spending more foreign currency than it is earning.
4. How is the Balance of Payments different from the Balance of Trade?
The Balance of Trade (BoT) is a narrower concept than the BoP. BoT only includes the value of a country's exports and imports of visible goods (like machinery, clothes, and electronics). The Balance of Payments, however, is much broader. It includes the BoT, plus the trade in services, investment flows, and financial transfers, giving a complete picture of a country's economic transactions.
5. Why is it said that the Balance of Payments always balances?
In an accounting sense, the BoP must always balance. This is because it is based on a double-entry bookkeeping system, where every transaction has two sides—a credit and a debit—that are equal and opposite. If there's a deficit in the Current Account, it must be financed by a surplus in the Capital Account (e.g., by borrowing from abroad) or by a decrease in the country's foreign exchange reserves. The sum of the Current Account, Capital Account, and official reserve changes will always be zero.
6. Can you give a simple example of how a transaction is recorded in the BoP?
Certainly. Imagine an Indian software company exports services worth $100,000 to a client in the USA. This transaction would be recorded as a credit (inflow) in the Current Account of India's BoP, as it brings foreign currency into the country. The corresponding debit would be the increase in the foreign assets (the payment received) held by the Indian company.
7. What does a persistent deficit in the Balance of Payments suggest about an economy?
A persistent BoP deficit often signals underlying economic weaknesses. It might indicate that a country is consuming more than it is producing, its industries are not competitive enough to boost exports, or it is heavily reliant on foreign borrowing to finance its consumption. Over time, this can lead to a depletion of foreign exchange reserves and pressure on the country's currency to devalue.
