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What is the Balance of Payments Formula (BOP)?
The formula for Balance of Payment is a summation of the current account, the capital account, and the financial account balances.
The term balance of payments refers to the recording of all payments and obligations pertaining to imports from foreign countries vis-à-vis all payments and obligations pertaining to exports to foreign countries. It is the accounting of all the financial inflows and outflows of a nation.
Mathematically, the balance of payments formula is represented as,
Explanation of the Balance of Payments Formula (BOP)
The formula for the calculation of Balance of Payments is calculated in the following four steps-
Step 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.
Step 2: Now, the balance of the capital account is determined which pertains to the disposal or acquisition of non-financial assets, which may include land or other physical assets. Basically, the products are required for manufacturing but have not been manufactured per se, for instance, an iron mine that is used for iron ore extraction.
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Step 3: Now, the balance of the financial account is determined which pertains to international monetary inflows and outflows related to investment.
Step 4: Finally, the equation for the calculation of Balance of Payments is by adding a balance of the current account (step 1), a balance of the capital account (step 2)and balance of the financial account (step 3)as shown above.
Example of Balance of Payments Formula (with 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 of the Balance of Payments Equation
Now, we will calculate the following values for the calculation of the Balance of Payments Formula.
The Balance of Current Account
- Balance of current account = Exports of goods + Imports of goods + Exports of services + Imports of services
- = $3,50,000 + (-$4,00,000) + $1,75,000 + (-$1,95,000)
- = -$70,000 i.e. current account is in deficit
Balance of Capital Account
- 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 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 do the calculation of Balance of Payments.
- Balance of Payments Formula = (-$70,000) + $45,000 + $60,000
BOP will be –
- The Balance of Payments = $35,000 i.e. overall the economy is in surplus.
Relevance and Use of Balance of Payments Formula
The concept of balance of payments is very important from the point of view of a country because it is the reflection of the fact that whether the country keeps enough fund to pay for its imports. It also demonstrates whether the country has enough production capacity such 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 it exports. In such a scenario the country is forced to borrow funds from other countries in order to pay off its imports. In the short term, such measures can fuel the economic growth of the country. However, in the long term, the country ends up becoming a net consumer of the economic output of the world. Such a country will be forced to go into more debt to pay for its consumption instead of investment in its own future growth prospects. If in case the deficit lasts for too long, then 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 of a country is in surplus, then it means that the country exports more services, goods and capital items than it does an import. Such a country and its residents are good savers. They have the potential to pay for all its domestic consumption. Such a country can even extend loans to other countries. In the short term, a surplus BOP can boost economic growth. 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 end up becoming too dependent on exports in the end. In such a country, a large domestic market can guard the country against the impacts of exchange rate fluctuations.
- As such, the balance of payments equation enables analysts and economists to understand the strength of the economy of a country in comparison to that of the 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.
This has been a guide to Balance of Payments Formula. Here we discuss the formula for calculation of Balance of Payments using practical example along with downloadable excel templates. You may learn more about Financial Analysis from the following articles –