Globalization has led to free transactions among countries in the world, making the world seem like a small village. Economics use different economic indicators to measure an economies’ performance. Transactions made are hence kept in records that are set by the countries internationally. These are the balance of payment and balance of trade.
What is a Balance of Payment?
It is the difference between the payments and total receipts of a specified economy during a certain period of time. It hence includes a summary of records of all transactions carried out by the residents of a particular economy with other economies all over the world.
Both cash flows and outflows generated by payments made by business firms, government entities and international trade is used in determining the balance of trade, which is computed quarterly, and annually.
It takes two components into consideration
- Capital account- this indicates transactions that are done on financial instruments
- Current accounts- It includes all transactions for buying or selling goods, services, investment income, and short-term transfers.
Balance of payments is computed by summing up the reserve balance, current accounts balance, and capital accounts balance.
The use of the balance of payments method has some advantages
- It is helpful in the understanding, evaluating and forecasting economic conditions
- It aids in determining the exchange value of a country
- It reveals the size, nature, direction, and composition of an economies international trade
- Clarifies the foreign exchange value of a country
- Helps the government make economic, industrial and trade policies
It, however, has some disadvantages
- External transactions of a country cannot be aggregated in physical units hence have to be converted into monetary units, which is a big problem.
- There are complications in the inclusion of transactions made by the central bank, government and other authorities
- Inadequate coverage and discrepancy of data are often experienced because the illegal transfer of funds and smuggling is not included in the balance of payments.
- There is no given standard mode of classifying external transactions of a country into categories which are deemed as appropriate and relevant
- There is a problem in the implementation of the agreements set out among the countries
What is a Balance of Trade?
It is the difference between imports and exports of a given economy during a certain period of time. It is important in measuring a country’s net income earned on international assets. In a situation where the exports are more than imports, there is a trade surplus, which is viewed as a favorable trade balance. On the other hand, an unfavorable trade balance is seen as a result of exports being less than imports.
Most countries create trade policies that encourage a trade surplus. They do this by selling more products and receiving more capital for the residents, which leads to a higher standard of living. When a trade surplus is achieved, trade protectionism is adopted, which helps in maintaining the trade surplus. This is done by protecting domestic industries by levying subsidies, quotas and tariffs on imports.
The value of the balance of trade is derived by subtracting the value of imports from the value of exports.
Advantages of balance of trade
- Records transactions that have taken place relating to both goods and services
- It is a true indicator of a country’s economic performance
It, however, has some disadvantage
- It always remains in balance because the payment side is always made to equal receipt side
Similarities between Balance of Payment and Balance of Trade
- Both are tools used to measure the economic performance of a country over a certain period of time
Differences between Balance of Payment and Balance of Trade
While balance of payment is the difference between the payments and total receipts of a specified economy during a certain period of time, balance of trade is the difference between imports and exports of a given economy during a certain period of time.
Balance of trade captures all visible and non-visible economic transactions in the world. On the other hand, balance of trade captures the value of goods on all exports and imports.
While balance of trade gives an overall view on the strength of a particular economy, the balance of trade gives a partial view, based on the imports and exports.
Balance of payments includes capital transfers while balance of trade does not include capital transfers.
While balance of payment records transactions that have taken place relating to both goods and services transactions, balance of trade records transactions that have occurred in relation to only goods.
Mode of Calculation
Balance of payment is computed by summing up the reserve balance, current accounts balance, and capital accounts balance. On the other hand, balance of trade is derived by subtracting the value of imports from the value of exports.
In balance of payment, the net effect is always zero. However, in balance of trade, the net effect is either positive, negative or zero.
Balance of Payment vs. Balance of Trade: Comparison Table
Summary of Balance of Payment vs. Balance of Trade
Although the computation is complex, the knowledge of balance of payments and trade cannot be ignored. These two methods have eased the analysis and comparison of economic conditions all over the world, by enabling a country record inflow and outflow of money.