Balance Of Payments Formula

Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Balance Of Payments Formula (BOP)?

The formula for the balance of payments is a summation of the current account, the capital account, and the financial account balances. The term balance of payments refers to recording all payments and obligations of imports from foreign countries vis-à-vis all payments and obligations of exports to foreign countries.

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Thus, it can be called as a comprehensive record of every economic transaction between two countries or between one country and the rest of the countries of the world, which can typically be a quarter or a year. It is an important tool for analysts and economists who use it to evaluate the financial condition of the country.

Balance of Payments (BOP) Formula Explained

The balance of payments formula is the record of total economic transactions between two countries or one country and the rest of the world’s economies. It gives the policymakers an idea about the economic condition and financial health of the country. The formula for balance of payments also gives them an idea regarding the relationship of the country with other economies of the world.

The three main components of the concept are the current account, capital account, and financial account. The current account deals with the trading of goods and services which include cars, food, machines, financial consulting and services, investments, gifts, grants, etc.  

The capital account deals with the disposal and acquisition of assets that are non-financial in nature, like patents, trademarks etc. The financial account is related to changes in country’s holding in foreign currency and gold, investment in securities like bonds and stocks, foreign direct investment, etc.

It is the accounting of all the financial inflows and outflows of a nation. The formula to assess the same is given below.

Balance of payments = balance of the current account + balance of the capital account + balance of the financial account

Therefore it is clear that this process helps evaluate the country’s ability to attract foreign investments due to a stable and financially strong economy. It also evaluates how much foreign exchange or foreign aid the country requires to cover its economic imbalances.

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How To Calculate?

The formula for the calculation of the balance of payments is calculated in the following four steps-

  1. Firstly, the balance of the current account is determined which is the summation of the credits and debits on various merchandise trade. The current account deals with goods, which may include manufactured goods or raw materials that are purchased or sold.

  2. Then, the balance of the capital account is determined, which pertains to the disposal or acquisition of non-financial assets, including land or other physical assets. The products are required for manufacturing but have not been manufactured per se, for instance, an iron mine used for iron ore extraction.

  3. Now, the balance of the financial account is determined, which pertains to international monetary inflows and outflows related to investment.

  4. Finally, the formula for the calculation of BOP is by adding a balance of the current account (step 1), a balance of the capital account (step 2), and a balance of the financial account (step 3), as shown above.

Examples

Let us understand the concept of the formula for balance of payments with the help of some suitable examples.

You can download this Balance of Payments Formula Excel Template here – Balance of Payments Formula Excel Template

Let us take the case of country A to calculate the balance of payments based on the given information and determine whether the economy is in surplus or deficit. The following information is used for the calculation:

ParticularsAmount
Current Account
Exports of Goods$3,50,000
Imports of Goods$4,00,000
Exports of Services$1,75,000
Imports of Services-$1,95,000
Capital Account
Net Capital Account Balance$45,000
Financial Account
Net Direct Investment$75,000
Net Portfolio Investment-$55,000
Assets Funding$25,000
Errors and Omissions$15,000

Now, we will calculate the following values to calculate the BOP formula

The Balance of Current Account

balance of payments formula example 1.2

Balance of Capital Account

balance of payments formula example 1.3
  • The balance of capital account =net capital account balance
  • = $45,000 i.e. capital account is in surplus

The Balance of Financial Account

balance of payments formula example 1.4
  • Balance of financial account =net direct investment + net portfolio investment + assets funding + errors and omissions
  • = $75,000 + (-$55,000) + $25,000 + $15,000
  • = $60,000 i.e. financial account is in surplus

Therefore, by using the above-calculated value, we will now calculate the balance of payments formula economics.

bop example 1.5
  • Balance of payments formula = (-$70,000) + $45,000 + $60,000

BOP will be –

bop example 1.6
  • The balance of payments = $35,000, i.e., overall, the economy is in surplus.

In the above example, we clearly get a detailed idea about the steps to be followed while using the formula and calculating the concept properly. The financial data of the economy gives a lot of inputs to the formula and calculation to ensure that the economists and policymakers can calculate and get a correct estimate regarding the economic condition of the country.

Relevance And Use

The concept of balance of payments is very important because it reflects whether the country has enough funds to pay for its imports. It also demonstrates whether the country has enough production capacity that its economic output can pay for its growth. Usually, it is reported on a quarterly or yearly basis.

  • If the balance of payments of a country is in deficit, then it means that the country imports more services, goods, and capital items than exports goods/services. In such a scenario, the country is forced to borrow funds from other countries to pay off its imports. In the short term, such measures can fuel the country’s economic growth. However, in the long term, the country becomes a net consumer of the world’s economic output. Such a country will be forced to go into more debt to pay for its consumption instead of investing in its future growth prospects. If the deficit lasts for too long, the country might have to start selling off its assets to pay for its debt. Examples of such assets are land, natural resources, and commodities.
  • If the balance of payments formula economics of a country is in surplus, it means that the country exports more services, goods, and capital items than imports. Such a country and its residents are good savers. They have the potential to pay for all their domestic consumption. Such a country can even extend loans to other countries. In the short term, a surplus BOPBOPThe BOP (Balance of Payment) is a calculation of all payments and receipts of several products and services between one country and the rest of the world during a certain time period.read more can boost economic growth. This is because they have enough savings to extend loans to those countries that buy their products.
  • Consequently, the increase in exports can boost the production requirement, which means hiring more people. However, the country might become too dependent on exports in the end. In such a country, a large domestic market can guard the country against exchange rate fluctuations.
  • As such, the balance of payments enables analysts and economists to understand the strength of the economy of a country in comparison to that of other countries. In addition, theoretically, the capital and the financial accounts should be balanced against the current account, i.e., BOPs should be zero, but that seldom happens.
  • The formula is a great source of academic research in the field of finance, economics and international trade. Using this the researchers and study the toics related to fluctuations in interest rates, trade related problems, change in international rules and policies and how they impact the domestic market, etc.
  • Policymakers can use this formula to forecast and predict any warning signals that can be rectified on time and save the economy form any sudden disaster.
  • Countries can refer to the data used in the calculation of the same to support their views and arguments during any discussion related to international diplomatic topics, trade relations, etc.
  • The policymakers of the country can also use this data to not only assess the economic condition but also frame and implement policies and procedures and take effective measures to correct the situation in case the country is consistently running a deficit in their balance of payments. This will reduce the pressure on imports and give a boost to exports.

Thus, it is a very important tool that can be used to evaluate the economic exchange and interaction made by a country with its neighbours. It helps the country to become self sufficient and strong and make a prominent place for itself in the global world.

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