A:

The balance of payments is simply a double-entry accounting system; it's based on corresponding debits and credits. Its purpose is to record payments and receipts from the residents of one country with residents of all other countries.

It's important to distinguish between the balance of payments and the current account. When the terms "trade deficit" or "trade surplus" are used in media, they are almost always references to the current account. The current account is just one part of the overall balance of payments, which also contains the capital account and financial account. 

When Balance of Payments Runs a Deficit

According to theory, it's impossible to sustain a deficit in the balance of payments. In practice, temporary imbalances do occur because of accounting difficulties.

In double-entry accounting, payments and receipts are necessarily equal. Thus, the balance of payments must theoretically always be equal as well. All current account transactions — what is normally thought of as international trade — are canceled out by capital and financial account transactions.

To see how this works, consider a scenario where Americans purchase $100 million worth of cars from German automakers, but Germans do not purchase anything from American businesses. Most Americans don't regularly hold euros, so the vast majority of those purchases are made in dollars.

Since the Germans aren't using those dollars to purchase U.S goods in this scenario, they have no choice but to hold deposits in U.S. banks or make other dollar-based investments in the U.S. The current account shows a deficit with Germany of $100 million. That is balanced out by a surplus in the capital and financial accounts, where $100 million worth of payments are made from the Germans to individuals, businesses and banks in the U.S.

What Causes Deficits in Balance of Payments?

The most obvious cause of a balance of payments deficit is called a "unilateral transfer." For example, U.S. residents who send money in the form of foreign aid to another country do not receive anything in return (economically speaking). Few economists would suggest that balance of payment deficits resulting from foreign aid are a "bad thing."

However, no accounting system is perfect. Most accounting rules are, in some sense, arbitrary and subject to timing irregularities. It gets particularly tricky to account for changes in value in the foreign exchange market. Those transactions are normally broken out and treated separately on one side of the balance of payments equation.

The flow of money (including gold) between central banks and treasuries is particularly sensitive to exchange-rate fluctuations. This often results in short-term deficits or surpluses from excess payments or receipts. In other words, the transactions that are recorded in the current and financial accounts might not balance out because of irregularities with the capital account.

The balance of payments is theoretically a monetary phenomenon. It implies the existence and value of money. According to this theory, a deficit in the balance of payments is actually a mechanism that adjusts an excess supply of money between the instance and recording of a transaction.

In the short-term, a balance of payments deficit isn't necessarily bad or good. It does mean that, in real terms, there is more importation than exportation occurring until the value of money adjusts.

RELATED FAQS
  1. What transactions are included in a country's balance of payments?

    Learn about the many types of transactions that are recorded in a country's balance of payments, including the current, capital ... Read Answer >>
  2. What is the difference between a current account deficit and a trade deficit?

    Learn the meanings of the macroeconomic terms "current account deficit" and "trade deficit," and understand the differences ... Read Answer >>
  3. What is the difference between the current account and the capital account?

    Learn how to differentiate between the capital account and the current account, the two components of the balance of payments ... Read Answer >>
  4. Is a current account deficit good or bad for the economy?

    Take a deeper look at the nature of a country's current account balance, and see why trade deficits are neither good nor ... Read Answer >>
  5. Understanding the Effects of Fiscal Deficits on an Economy

    Understand what fiscal deficits are and understand the real impact of budget deficits on the economy. Learn why government ... Read Answer >>
  6. What happens to the US dollar during a trade deficit?

    Learn what happens to the U.S. dollar during trade deficits. Trade deficits happen when imports exceed exports leading foreigners ... Read Answer >>
Related Articles
  1. Insights

    The Pros & Cons of a Trade Deficit

    Is a trade deficit, also known as a current account deficit, beneficial or detrimental to a country's economy?
  2. Insights

    Exploring the Current Account in the Balance of Payments

    Learn how a country's current account balance reflects the country's economic health.
  3. Insights

    The Balance Of Payments

    The "Balance of Payments" is a record of all payments or monetary transactions between a particular country and other nations during a specific time period. It provides a useful glimpse into ...
  4. Investing

    What's the Balance of Trade?

    The balance of trade is the difference between the value of all the goods and services a country exports and the goods and services it imports.
  5. Investing

    Understanding Capital And Financial Accounts In The Balance Of Payments

    The current, capital and financial accounts compose a nation's balance of payments, indicating the state of its economy and economic outlook.
  6. Investing

    Why Money Flow From Japan Matters to the U.S. Equity Market

    Discover why Japanese savers and investors may have a lot to say about the future of the U.S. equity market, and why the trade deficit is responsible.
  7. Personal Finance

    6 Things You Didn't Know About The U.S. Budget Deficit

    The country appears to be spiralling into more debt all the time, but is it really as bad as it looks?
  8. Insights

    The Current State of the U.S. Debt

    Discover the current state of U.S. national debt, whether it's increasing or decreasing, and what is projected for the next 10 years.
RELATED TERMS
  1. Trade Deficit

    A trade deficit occurs a country's imports exceeds its exports. ...
  2. Basic Balance

    Basic balance is an economic measure for the balance of payments ...
  3. Deficit

    A deficit is the amount by which a resource falls short. It is ...
  4. Fiscal Deficit

    When a government's total yearly expenditure exceeds its yearly ...
  5. Current Account Surplus

    A current account surplus is a positive current account balance, ...
  6. Balanced Trade

    Balanced trade is an economic model under which countries engage ...
Trading Center