They reflect the transactions made by the country with the rest of the world in terms of goods, services and capital and they are used as key indicators to make economic, financial and monetary decisions.

What is Balance of Trade?

The Balance of Trade, or BoT in short, is the difference between the value of a nation’s exports and imports during a given time frame. It is also known as international trade balance, commercial balance or net exports, and it is the largest elements of a nation’s Balance of Payments.

What is Balance of Payments?

The Balance of Payments, or BoP in short, is the sum of the balance of trade, the balance of services, the balance of unilateral transfers, and the capital account.

The BoP is also known as balance of international payment and it covers all transactions that persons, companies and government entities from one country make with individuals, companies and government entities from other countries.

These transactions involve imports and exports of goods, services and capital, as well as money transfers, such as foreign aid and remittances.

This statement is a set of accounts that identify all the commercial transactions made by the nation in a specific period with the remaining nations of the world.

The Balance of Payments groups transactions in two main sections: the current account or Balance of Trade, and the capital account. The Balance of Trade records imports and exports of goods and the capital account, broadly defined, includes transactions involving capital and central bank reserves.

Sometimes the capital account is divided into capital account and financial account. The capital account reports transfers of ownership of assets and other non-productive transfers of rights or assets that are not related to a current ongoing productive activity. For example, assets such as land or machinery. On the other hand, the financial account reports transfers of financial assets. In other words, it tracks the changes in ownership of domestic and foreign financial assets.

In theory, the Balance of Payments must be always in equilibrium. Transactions in the current account are mirrored by transactions in the capital account. However, the complexity of real-life transactions usually differs from this theoretical standpoint and several adjustments have to be made to make sure the accounts are balanced.

Key Takeaways

Balance of Trade and Balance of Payments Formulas

The calculation of the Balance of Payments includes the formula of the Balance of Trade, as shown below.

Balance of Payment = Balance of Trade + Capital Account

Where,

Balance of Trade = Total value of exports – Total value of imports

Key Differences Between Balance of Payments and Balance of Trade

Scope

The Balance of Payments includes the Balance of Trade and the capital account so the Balance of Payment is a broader measure of the country’s financial situation.

In contrast, the Balance of Trade records only good-related transactions, not capital movements as it shows the amounts associated with imports and exports of goods, which is just a partial view of the nation’s finance.

Measurement

The result of the BoT may be favorable when total exports exceed total imports, which is called a surplus and it may be unfavorable when total imports exceed total exports, which is called a deficit. Or it may be in equilibrium when both amounts are approximately equal.

The Balance of Payments statement, on the other hand, includes trade transactions and inflows and outflows of services, unilateral transfers and capital transactions.

Analysis

By evaluating the Balance of Trade by itself it is impossible to determine how the deficit was financed or where the surplus went. The Balance of Payment provides those answers as every credit in the current account is balanced with a debit in the capital account and vice-versa.

When there is a large trade surplus the country is importing foreign capital as other nations pay for the goods that are being exported. On the other hand, when there is a large trade deficit and the country hasn’t received any significant capital inflows, the country’s reserves are drained.

Services

The Balance of Trade doesn’t include any services, not even the import and export of services, as the Balance of Payment covers this matter. The net result of the Balance of Trade serves as guidance to understand the net output produced by the country’s economic activities.

Economic Impact

The impact of economic and monetary policies is ultimately captured by the Balance of Payments.

For example, a government could decide to increase foreign investment in a particular sector and, therefore, the capital account will receive inflows.

Another case might be when a country decides to maintain an artificially low exchange rate and exports are encouraged.

Balance of Trade and Balance of Payments Examples

The following example shows a simplified exercise of a transaction recorded in the Balance of Payments. Let’s say that a small country has $4 billion in exports and $3 billion in imports.

In the following period, exports remain the same but imports increase by $2 billion to reach $5 billion. The Balance of Trade changed from a surplus to a deficit from one period to the other.

That deficit has to be financed in some way. The country did not increase exports of capital so the country’s gold reserves, which is an asset, were sold by the government to other countries to finance the deficit.

When selling the gold, that asset was exported to balance the deficit. A debit was recorded in the current account and a credit was recorded in the capital account as a result of these transactions.

Bottom Line

The BoT and the BoP are both important statements that indicate how the country manages its accounts and how the situation changes from one period to another in relation to inflows and outflows of goods and capital.

They both provide a comprehensive picture of the country’s transactions that help policymakers in making economic and monetary decisions. The analysis of the BoT and BoP accounts is not an easy task in real life but by understanding the what each of them mean may help analysts in predicting the potential performance of a country during future periods.

Frequently Asked Questions

What distinguishes the balance of trade from the balance of payments in economic terms?

The balance of trade refers to the difference between a country’s exports and imports of goods, while the balance of payments encompasses all economic transactions between residents of a country and the rest of the world, including trade, financial transfers, and investments.

How does a surplus in the balance of trade affect the balance of payments?

A surplus in the balance of trade, where exports exceed imports, can contribute positively to the current account component of the balance of payments, reflecting a net inflow of money from foreign markets.

Can a country have a favorable balance of trade but an unfavorable balance of payments?

Yes, a country can have a favorable balance of trade with exports exceeding imports but still have an unfavorable balance of payments if outflows from other transactions, such as foreign investments or debts, outweigh the trade surplus.

Why is the balance of payments considered a broader measure than the balance of trade?

The balance of payments is a broader measure because it includes the balance of trade along with all other financial transactions, such as cross-border investments and loans, providing a comprehensive view of a country’s economic transactions with the world.

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What Does Qualitative Analysis Mean?

Statistically speaking and from a business standpoint, most analytical tools are based on numbers and what you can get from them. Nevertheless, there is another major field that is based on characteristics that can’t be portrayed by using figures and these are explained through qualitative analysis.

By including these elements, a researcher can have a better grasp on the personality or behavior of certain subject and judgments about character and attributes can also be extracted from this type of assessment. From a marketing perspective, this field is essential to describe customers, market segments and competitors by using demographic items such as gender, geographical location, behavior patterns, frequency of consumption or favorite outdoor activities.

A company can develop a person or a company’s profile with qualitative analysis and it can develop strategies and courses of actions to use those elements on its behalf. Nevertheless, qualitative variables are more difficult to analyze than numerical values since they require certain treatment in order to be properly presented for decision-making purposes.

Example

Los Burritos LLC is a Mexican food company that offers gourmet dishes to high-end customers. The company was founded by Americo Valente, a Mexican immigrant that saw an opportunity to bring high-quality Mexican food into the U.S. market. He got the idea of opening the restaurant after reading a report that affirmed that 85% of Americans were open to try foreign dishes and 34% of them preferred gourmet-level food rather than fast food.

He identified a market niche within this information as all the qualitative variables were inclined positively towards foreign gourmet-level restaurants. Los Burritos is now a huge success. They have more than 35 restaurants across the West Coast and they are planning to keep opening new ones each year.

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What Does Monetary Value Mean?

Nowadays almost everything has monetary value. The modern economic system governing nearly the entire world imposes a price in cash for each good and service. Any kind of items such as houses, lands and personal goods has monetary values but also labor and services and even intangible goods such as patents and property rights.

Monetary value is usually set in competitive markets through supply and demand, which are the invisible forces that define prices. This is not applicable when the government regulates heavily the market or there is a small number of suppliers and buyers to make it competitive.

In addition, particular situations or events might dramatically change the monetary value of an item, especially in non-competitive markets. For example, a coat can have a price of US$120 in a populated city but a person who lost his coat at a cold mountain could be willing to pay much more.

Example

Lisa Hamilton used to prepare a large cake every Friday for a orphanage located nearby as a nice evening snack for the children that lived there. The cake was not common because it was a special recipe that she learned from a Latin American friend years ago. Lisa was recently fired because of financial problems faced by her employer and therefore she became suddenly unemployed.

A friend of her suggested that she could sell those cakes to earn some income. But Lisa did not know the monetary value of the cake because she always gave it for free. After doing some research among friends and relatives, they told Lisa that every cake could be sold at US$15, because of the unique ingredients and flavor. She was glad to hear it and thus started what became a few months later a prosperous business.

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What Does Bribery Mean?

In business, many companies allocate massive financial resources in contracts, this makes bribery a very appealing idea for some people. Bribery intends to reach a hidden agreement between the person who decides and the person who wants to be granted with the contract. As the money involved is higher, the likelihood of bribery situations tends increase. Sometimes bribery is a direct, clear proposition but in other instances it is more like a nice gift that places the donator in an advantageous position against the remaining contenders.

Company’s stakeholders always expect that contracts are granted to the best contender in terms of qualifications and requirements so the decision maker has the legal and moral obligation of fulfilling such expectation. All companies must be aware of bribery and its negative consequences. A useful anti-bribery strategy is to talk honestly and openly about actions that are considered as bribery and penalties to employees participating in such situations.

In some cases it is advisable to delegate decisions to committees instead of single employees. Supervision and control systems must exist with the purpose of identifying possible bribery cases adequately.

Example

Carlos Nuñez is a manager who was assigned to a large construction project in an African country. He works for a Portuguese company that has recently initiated operations in foreign countries. He will allocate more than 1 million dollars in five contracts through some bidding procedures that lack the supervision of the central office.

A person owning one of the competitor companies offered an attractive amount of money to Carlos if the decision favored his business. However, that company did not seem as an adequate candidate to fulfill the required work. Carlos refused the bribe and finally chose the best participants available for the contracts.

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What Does Rational Choice Theory Mean?

This theory has a few important founding premises such as individualistic human behavior, a self-centered motivation, a constant pursue for optimal results at each decision-making situation and finally, the possession of all the required information to produce a rational analysis from each scenario.

Even though this theory is clearly not entirely accurate in reality it established a useful starting point to develop further theories such as supply and demand theory, income distribution theories and utility theory.

All these had to use rational choice theory (RCT) as a baseline to develop subsequent hypothesis, since it would be impossible to draw conclusions from a scenario where everyone decides based on irrationality. Although human behavior cannot be described as rational in all decision-making situations, there is an underlying tendency for individuals to pursue optimal results when choosing between different alternatives.

Example

Carl is currently engaged with Laura. They are both looking for a nice department to rent so they can move together after they get married. They have seen ten different options; each of them with several pros and cons. Carl thinks the best alternative is a small flat located in the hearth of the city, close to where he works. Laura, on the other hand, believes the best place is the one located in the suburbs, since it is much bigger than the flat, as she is thinking in the future.

Rational choice theory would dictate in such scenario that both Carl and Laure will evaluate all the alternatives and decide rationally on which one is the best. Nevertheless, as it can be obviously interpreted, there are subjective elements in place that will probably deviate the decision from what would seem to be the rational one.

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What Does Public Spending Mean?

Governments need to spend on goods and services to carry out a wide range of activities. Central and local governments as well as state-owned companies are also included in this matter. Most of that money is obtained through taxation. Public spending tends to have a huge impact on the economy. As governments purchase goods and services many companies produce profits, hire people and consume materials and inputs.

Indeed, higher public spending generally drives economic growth, at least in the short-term. In contrast, lower spending reduces economic growth. Other forms of spending are transfer payments to people like unemployment allowance and pensions. Economists often recommend that public spending should be limited to activities and functions that fit in the purest role of the government. These are actions that try to correct the so-called market failures and to provide public goods.

This means, to do what the free market cannot do on its own. Any other type of spending would be inefficient, under the assumption that resources are more efficiently allocated by the private sector than by the State. Nevertheless, many decisions in relation to public spending are based on political motivations instead of technical analysis. Some governments increase spending on social programs just a few months before an election with the aim of gaining advocates.

Example

A small town called Ishiwa in Japan is currently aiming to provide better public services to its residents. The town’s mayor has designed a plan that includes gas, electric and water distribution concessions that will be granted to private companies.

This project also includes a considerable amount of money that needs to be invested in building certain structures required to improve the current town’s infrastructure, such as street lights and bus stops. The funds required to finance such project will come from the federal government, private companies and tax income.

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What Does Labor Market Mean?

Like any kind of market, a free, competitive labor market is the most efficient way to allocate labor resources and to establish salaries. Workers offer their skills and organizations offer payment in exchange. The amount and kind of work demanded and supplied at a certain moment is the force that drives results.

That means that higher demand causes greater wages, while higher supply causes the opposite effect. If there are enough participants to make the market highly competitive, no individual player can alter the output. Certainly, no labor market is entirely free because governments usually intervene to set minimum wages and working conditions through labor laws.

Unemployment allowances granted by the government would also affect the way workers react to low-wage jobs. On the other hand, individuals might find other motivations to work besides purely money.

Example

Hannah Smith is a young professional recently graduated from college. She was an excellent student that aspired to have a great life in the future thanks to well-remunerated jobs. Hannah told her father that she would demand an annual wage of US$70,000. Her father explained that she is not in total control of her next salary. Her good grades certainly would help but she would enter in an existing labor market of professionals with similar qualifications.

The market establishes the conditions and the price of her work is probably already set. He recommended Hannah to do superior studies to be able to participate in another market with higher wages. Hannah was reluctant and tried to find a job at that moment but she was disappointed when companies offered wages that ranged US$40,000-50,000. A few months later, Hannah accepted the advice and decided to enroll in a graduate program.

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What Does Competitive Landscape Mean?

Every company should monitor its competitive landscape. This involves embracing information about each of its participants, their products, prices, market share, current strategies and main strengths and weaknesses.

Since the company is not alone in the market, it is indispensable to understand who the rivals are and how they usually perform with the purpose of improving its own market position. Direct and indirect competitors should be identified and analyzed. This valuable information will support decision makers when defining and evaluating company strategies.

The analysis should start by defining the relevant market. Only similar products should be considered as competitors or substitutes. As the company increases the number and variety of products and lines the competitive landscape will become more complex.

Example

Cindy Cakes is a firm that sells pound cakes to supermarkets located in a small city. The General Manager thinks that Cindy Cakes could raise prices in 15-20% because there is no other brand offering pound cakes to supermarkets.

However, the company’s Marketing Manager said that competition comes from other sweet bakeries too. If prices increase considerably, some consumers are likely to shift to other sweet options available on the shelves. He identified that there were at least five companies that offered about 25 sweet bakery products in supermarkets located in the city.

Moreover, he considers that ice cream and ice cream-based desserts are competitors too. After an analysis of the competitive landscape the company decided that prices should be increased only in 5% and that new low-calorie varieties should be developed and sold at higher prices.

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What Does Trade Reference Mean?

Trade references can be used in a wide range of business situations but they are mostly seen as requirements asked by credit suppliers. Banks, lenders ad suppliers that grant credits demand trade references to their customers. Although it is impossible to foresee if a person will pay a debt within the expected terms, information about past behavior is often used as a good predictor.

The reference itself can be as simple as a name with its correspondent contact information. In this case, the lender calls to that name and asks some questions that aim to verify the credit record of the potential borrower. In other cases, the requirement is a letter with the opinion, precise data about the past or present credit and complete contact information.

A trade reference should come from a credible individual or entity, not closely related to the beneficiary. It is not very valuable when a relative acts as a reference because there might be personal interests distorting the actual information.

Example

Mr. James Gordon plans to start a new business venture. He will buy clothes to a large manufacturer and distribute them to small stores. The firm demands a minimum amount of 100 items per purchase so Mr. Gordon needs to make the initial purchase on credit.

The manufacturer is asking for a trade reference before granting the credit line. Mr. Gordon remembered that a car seller could be a good reference because his car was purchased through a four-year loan. The manufacturer contacted the seller, who properly informed that Mr. Gordon certainly borrowed an amount of money for the car and he assured the company that each pending payment was timely and entirely covered.

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What Does Social Learning Mean?

Human relationships are essential to build a person’s perspective about society and moral values. The theory of social learning evaluates the way these interactions create or modify the behavior of individuals from a collective standpoint. A child, for example, learn different reactions and attitudes by watching his parents and the people around him.

This means that he will adopt the behavior he sees in his references, which are the individuals that are more close to him during his early stages. After the person matures, certain attitudes and view points are more fixated in the individual’s mind but there is always the possibility of a paradigm shift that redefines the way he sees the world or reacts to certain things.

This can also be applied to work environments, where individuals learn from co-workers the culture of the business they work at. They also learn different behaviors that are part of the dynamic of the workplace and this leads to a collective attitude that tends to be similar even though each individual has a different personality.

Example

Paul was recently hired by a global consulting firm that provides tax and financial advisory services to large companies that are normally based in the U.S. He doesn’t know much about the consulting business but he is willing to learn.

His boss explained that most of the things he needs to learn about the way the company do business will be observed during work sessions and meetings with clients. Paul has the opportunity to work with many of his co-workers in these environments and as social learning theory states, he will create or modify some of his attitudes and reactions depending on the culture he sees during these interactions.

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