Toronto Metropolitan University

FIN 621

The Balance of Payment (BOP)
• The measurement of all international economic
transactions between the residents of a country and
foreign residents is called the balance of payments
(BOP)
• A nation’s balance of payments interacts with
nearly all of its key macroeconomic variables
• Interacts means that the BOP affects and is
affected by such key macroeconomic factors as:
– Gross Domestic Product (GDP) = C + I + G + X - M
– The exchange rate
– Interest rates
– Inflation rates
The BOP and Exchange Rates
(X – M) + (CI – CO) + (FI – FO) + FXB = BOP
Where:
X = exports of goods and services
M = imports of goods and services
CI = capital inflows
CO = capital outflows
FI = financial inflows
FO = financial outflows
FXB = official monetary reserves
} Current Account
Balance
} Capital Account
Balance
} Financial Account
Balance
Fixed Exchange Rate Countries: Under a fixed exchange rate system, the government bears the
responsibility to ensure that the BOP is near zero
Floating Exchange Rate Countries: Under a floating exchange rate system, the government has
no responsibility to peg its foreign exchange rate
Managed Floats: Countries operating with a managed float often find it necessary to take action
to maintain their desired exchange rate values
Current account + Capital account + Reserves
 Balance > 0 = inflow of capital, quantity demanded of home currency > quantity
supplied, upward pressure on home currency value
 Balance < 0 = Outflow of capital, quantity demanded of home currency < quantity
supplied, downward pressure on home currency value
- Equilibrium can continue indefinitely, disequilibrium cannot.
- If the balance is not zero for long time, it is a disequilibrium and will be corrected by
the market in the long run
- several scenarios possible, material for international economics course
Price of home currency is the exchange rate:
# Units of local currency / 1 unit of foreign currency (direct)
# Units of foreign currency / 1 unit of local currency (indirect)
Foreign Exchange Market: market spans the globe, with prices
moving and currencies trading somewhere every hour of every
business day.
Foreign exchange means the money of a foreign country; that is,
foreign currency bank balances, banknotes, checks and drafts.
A foreign exchange transaction is an agreement between a buyer
and a seller that a fixed amount of one currency will be delivered for
some other currency at a specified date.
Transactions in the Interbank Market: