What is the balance of payments?
The balance of payments (BOP) records all transactions between residents of a country and the rest of the world. It is divided into the current account, the financial account and the capital account. This chapter focuses on the current account.
Components of the current account
| Component | Description | Examples |
|---|---|---|
| Trade in goods (visible balance) | Exports minus imports of physical goods. | Cars, oil, machinery, food products. |
| Trade in services (invisible balance) | Exports minus imports of services. | Tourism, financial services, education, transport. |
| Primary income (investment income) | Net income from investments abroad (profits, dividends, interest) and compensation of employees. | Dividends received from foreign companies; wages paid to workers across borders. |
| Secondary income (transfers) | Net transfers without a quid pro quo. | Remittances, foreign aid, gifts, pensions paid abroad. |
Current account balance
The current account balance is the sum of all four components. A current account surplus occurs when a country exports more goods, services and income than it imports; a current account deficit is the opposite. Persistent deficits may indicate that a country is living beyond its means and financing consumption through borrowing.
Causes of deficits and surpluses
- Competitiveness – countries with efficient industries, high productivity and innovative products tend to run surpluses.
- Exchange rates – an overvalued currency makes exports expensive and imports cheap, leading to deficits.
- Economic growth – fast growth may boost imports of capital goods and consumer goods.
- Domestic savings and investment balance – if investment exceeds savings, the country finances the gap through foreign borrowing, resulting in a deficit.
Policies to reduce a deficit
- Expenditure switching policies – devaluing the currency or imposing tariffs to encourage consumers to switch from imports to domestic goods.
- Expenditure reducing policies – contractionary fiscal or monetary policy to reduce overall spending in the economy.
- Supply‑side policies – improving productivity, quality and innovation to make exports more competitive.
It is important that measures to correct a current account deficit do not conflict excessively with other macroeconomic objectives, such as maintaining growth and employment.
Examples and applications
The United States has run a current account deficit for decades, importing more goods and services than it exports. This deficit is financed by foreign investment in US assets such as government bonds. While the deficit reflects strong domestic demand and attractive investment opportunities, it raises concerns about reliance on foreign capital.
Germany and China, by contrast, have sustained current account surpluses. These surpluses result from competitive manufacturing sectors and high levels of domestic saving. Surpluses allow countries to accumulate foreign assets but may also lead to accusations of unfair trade practices if they arise from undervalued currencies or market barriers.
Countries with large deficits often use a mix of expenditure switching and reducing policies. For example, the United Kingdom devalued the pound in 1992 and 2008 to boost exports and reduce imports. However, devaluation can also increase the price of imported goods and contribute to inflation.
