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The relationship between the amount of money a country spends abroad and the amount it gets from other nations. The balance of payments concept includes not only trade in goods and services, but also the movement of other capital, such as development aid, foreign investment, military expenditures and the repayment of public debt.
Nations have to balance their long-term income and expenditures in order to maintain a stable economy, because, like individuals, a country can not be eternally in debt. One way of correcting a balance of payments deficit is by increasing exports and decreasing imports, and government control is often necessary to achieve this goal. For example, a government may devalue its currency to make domestic goods cheaper and thus to make imports more expensive
The term balance of payments may also refer to the accounting record of all international economic transactions carried out by a country in a given period of time (usually one year)
Balance of payments composition
1. Current account
• Balance of trade
• Balance of Services
• Balance of Transfers
1. Capital account
• Foreign direct investment
• Indirect Foreign Investment
Balance of payments accounts
The balance of payments is the record of the transactions of the residents of a country with the rest of the world. There are two main accounts in the balance of payments: the current account and the capital account.
The current account records the exchange of goods and services, as well as transfers. Services are freight, royalty payments and interest payments. Transfers consist of remittances, donations and aid. We speak of a current account surplus if exports are greater than imports plus net transfers to foreigners, that is, if revenues from trade in goods and services and transfers are greater than payments for these items.
The trade balance simply records trade in goods. If trade in services and transfers are added, we reach the current account balance.
The capital account records purchases and sales of assets, such as stocks, bonds and land. There is a capital account surplus, or a net inflow of capital, when our income from the sale of stocks, bonds, land, bank deposits and other assets is greater than our payments due to our purchases of foreign assets.
Surplus and deficit
The basic rule for the development of balance of payments accounts is that any transaction that gives rise to payment by the residents of a country is a deficit heading. Thus, imports of automobiles, the use of foreign vessels, gifts to foreigners or deposits in a bank in a country, are all deficit headings. On the other hand, it would be surplus headcount, on the contrary, sales of American planes abroad, payments made by foreigners to acquire licenses from another country for the purpose of using technology of the same, foreign pensions received by the residents of a country.
The overall balance of payments is the sum of current and capital accounts. If both the current account and the capital account have a deficit, then the global balance of payments also has a deficit. When one account has a surplus and the other has a deficit of exactly the same amount, the balance of the overall balance of payments is zero, that is, there is neither surplus nor deficit. We collect these relations in the Equation:
Balance of payments surplus = Current account surplus + surplus by capital account.
International payments
Any transaction that originates a payment made by residents of a country to residents abroad is a deficit heading. A global deficit of the balance of payments – the sum of the current and capital – means that payments made by residents of that country to foreigners are greater than the residents receive from foreigners.
Since foreigners want to be paid in their own currencies, the question arises as to how these payments should be made.
When the balance of payments has a deficit – when the sum of current and capital is negative – residents have to pay foreigners a larger amount of foreign currency than they receive, Foreign central banks provide foreign currency necessary to Make payments abroad, the net amount offered is the official booking transactions.
When a country’s balance of payments has a surplus, foreigners have to obtain the dollars with which they will pay the excess of their payments to that country on their income from sales to the country. Money is provided by central banks.
Balance of payments and capital flows.
Introducing the role played by capital flows in a context where we assume that our country is faced with established import prices and export demand. We assume that the world interest rate is given and that capital enters the country at a rate that is greater the greater the domestic interest rate. That is, foreign investors buy a number of our assets that will be higher the higher the interest rate our assets pay in relation to the world interest rate. The rate of capital inflow or surplus of the capital account is a growing function of the interest rate. When the interest rate is equal to the world rate, i = i, nor are there any capital flows. If it is higher, there will be an inflow of capital, and conversely, if it is lower, there will be an exit.
An increase in income worsens the trade balance, and an increase in the interest rate increases capital inflows and improves, thus, the capital account. It follows that when income increases, an increase in interest rates could keep the balance of payments overall in balance. The trade deficit would be financed by an inflow of capital.
This idea is extraordinarily important. Countries often face the following dilemma: domestic production is low and they want to increase it, but the balance of payments has difficulties and they do not think they can afford an even greater deficit. If the level of income increases, net exports will decline as domestic demand rises, thus worsening the balance of payments’ which is something the country wants to avoid. The existence of capital flows sensitive to the interest rate suggests that we can carry out an expansive domestic economic policy without necessarily incurring balance of payments problems.
A country can withstand an increase in domestic income and expenditure on imports, provided it is accompanied by an increase in interest rates, which is capable of provoking capital inflows. But how can we achieve an expansion of domestic income at the same time that interest rates increase? Using fiscal policy to increase aggregate demand to the level of full employment and monetary policy to achieve the appropriate amount of capital flows

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