International Trade: Balance of Payments and PPP

The Balance of Payments and International Transactions

The Balance of Payments (BOP) accounts of a country record the payments and receipts of the residents of the country in their transactions with residents of other countries. The BOP records all flows of value between a nation’s residents and the rest of the world. It summarizes international transactions for a specific period, usually a year, and is prepared in a single currency, typically the domestic currency for the country concerned. When all components of the BOP sheet are included, it must sum to zero with no overall surplus or deficit.

1. The Current Account

The current account shows the net amount a country is earning if it is in surplus, or spending if it is in deficit. It is called the current account as it covers transactions in the "here and now." Because the current account and the capital account add up to the total account, which is necessarily balanced, a deficit in the current account is always accompanied by an equal surplus in the capital account, and vice versa.

2. Capital and Financial Account

The capital account records the net change in ownership of foreign assets.

• Capital inflows: Increases in a nation’s liabilities to foreign residents or decreases in assets held in other countries.
• Capital outflows: Increases of a nation’s assets in a foreign country or decreases in its liabilities to other countries.

Recording Flows in the BOP

When recording transactions in the BOP, the following rules apply:

• Only flows are recorded (no stocks).
• Transactions must take place in the year for which the BOP is being recorded.
• Only transactions between an economic resident and a non-economic resident are included.
• Any exchange between two countries involves two opposite flows of equal value (credit and debit).
• Any exchange enters the BOP twice.

The Foreign Exchange Rate

Different currencies are used for international trade and investment (divisas). The foreign exchange rate is the price of one currency in terms of another currency. The foreign exchange rate is determined in the foreign exchange market, a market in which currencies of different countries are traded and where the foreign exchange rates are determined.

Purchasing Power Parity (PPP)

The exchange rate of a country tends to equalize the cost of buying traded goods at home with the cost of buying those goods abroad. Countries with a high rate of inflation have a tendency toward the depreciation of their currencies. The theory of Purchasing Power Parity (PPP) may be a useful indicator of how exchange rates will behave in the long run.