Question

What is meant by the balance-of-payments?

Short answer

The balance-of-payments is a comprehensive record of a country’s fiscal transactions, including the imports and exports of goods, services, and capital, as well as financial transfers. It is divided into three categories: the current account, the capital account, and the financial account, used to define the economic, investment, trade relationships a country has with the rest of the world.

Step-by-step solution

Define the Term

Balance of payments is a comprehensive record of a country’s fiscal transactions, including the imports and exports of goods, services, and capital, as well as financial transfers. It is used to summarize all international economic transactions for that country during a specific time period.

Explain its Components

The balance of payments is typically divided into three categories: the current account (which includes goods and services into and out of the country), the capital account (which includes capital transfers and purchasing of fixed assets), and the financial account (which includes investments into and out of the country).

Describe its Purpose

This measurement is used to define the economic, investment, trade relationships a country has with the rest of the world. Economists and policymakers use it to help formulate countries' economic policy.

Key concepts

current account

The current account is a crucial component of a country's balance of payments, providing a snapshot of its economic dealings with the rest of the world in terms of goods and services. Essentially, it reflects the net trade in goods and services, along with earnings on investments and transfers.

The current account can be broken down further into several subcategories:

• Trade in goods: This includes the export and import of physical items like machinery, clothing, and electronics.
• Trade in services: These are non-tangible products, such as financial services, tourism, or IT services.
• Primary income: Earnings from foreign investments, such as dividends and interest, fall under this category.
• Secondary income: This is where you'll find personal transfers and remittances from abroad.

In essence, a surplus in the current account indicates that a country is exporting more than it is importing, which can be a sign of economic health. Conversely, a deficit might suggest that the country relies heavily on foreign goods and services.

capital account

The capital account plays a unique role in the balance of payments by recording capital transfers between countries. While not as vast as the current account, it captures some specific financial flows that are crucial for international financial reporting.

Let's explore the main components:

• Capital transfers: These involve the transfer of ownership of fixed assets or the forgiveness of debts. For instance, a government may cancel a developing country's debt.
• Acquisition/disposal of non-produced, non-financial assets: This is about transactions that deal with assets like patents, copyrights, and trademarks.

Although the capital account is often smaller and less frequently discussed than the other accounts, it remains a vital part of understanding global financial transactions. Balanced capital accounts help indicate stable economic relationships between countries.

financial account

The financial account provides insights into a country's foreign investment landscape by recording all changes in financial claims. It helps track investment flows entering and leaving a country.

This account comprises three main sections:

• Direct investment: This is about establishing a lasting interest in a foreign enterprise, often by acquiring a substantial ownership stake. For example, a company building a factory abroad.
• Portfolio investment: It involves buying financial assets, like stocks and bonds, without assuming control over the business operations.
• Other investments and reserve assets: This covers various other financial transactions, like interbank loans or central bank reserves.

The financial account is key for measuring how attractive a country is to foreign investors. It reveals whether more money is flowing into the country's financial markets or out, indicating the nation's economic confidence in the eyes of global investors.