What is the balance of payments?
The balance of payments (BoP) is a systematic record of all economic transactions between a country's residents and non-residents over a period. Under the current international standard, the IMF's BPM6 (2009), it has three main parts:
- Current account: goods, services, primary income (wages, dividends, interest) and secondary income (transfers).
- Capital account: capital transfers and transactions in non-produced, non-financial assets such as patents.
- Financial account: direct investment, portfolio investment, financial derivatives, other investment and reserve assets.
Because entries follow double-entry bookkeeping, the accounts sum to zero in principle, with any statistical gap recorded as net errors and omissions. A "surplus" therefore usually refers to a particular account, typically the current account.
Classical view: the price–specie–flow mechanism
In "Of the Balance of Trade" (1752), David Hume described automatic adjustment under the gold standard. Gold (specie) flows into a surplus country, raising its money supply and prices, while the deficit country loses gold and its prices fall. The surplus country's exports then decline and the deficit country's rise, so the balance returns to equilibrium by itself. The argument was aimed at mercantilist calls to pile up trade surpluses.
Elasticity approach
This approach asks how strongly export and import volumes respond to exchange-rate changes. Its centrepiece is the Marshall–Lerner condition: a devaluation improves the current account only if the sum of the price elasticities of export and import demand exceeds one. Because contracted volumes do not change at once, the balance often worsens just after a devaluation and improves later, the J-curve effect.
Absorption approach
Starting from the Keynesian national income identity, Alexander (1952) treated the current account as national income minus domestic absorption (consumption + investment + government spending). Devaluation alone is not enough: a deficit shrinks only if output rises or domestic spending falls.
Monetary approach
In the 1970s Harry Johnson, Jacob Frenkel and others treated the balance of payments as a monetary phenomenon. Under fixed exchange rates, if the money supply exceeds domestic money demand, the excess money leaks abroad as spending, creating a deficit that is corrected through changes in reserve assets.
Goschen's theory and exchange rates
In The Theory of the Foreign Exchanges (1861), the British economist George Goschen argued that exchange rates are set by the supply of and demand for foreign currency arising from a country's international claims and debts. Known in Korean textbooks as the "international indebtedness theory", it is an early attempt to explain exchange rates from the balance of payments. It does not, however, explain why those claims and debts change, and later work developed it alongside purchasing power parity into broader exchange rate determination theories.
Limitations
Each approach highlights one side of the economy. With today's large capital flows, financial-account movements strongly affect exchange rates and the current account, so the approaches are usually combined. Trade patterns themselves are easier to understand alongside comparative advantage.
Sources reviewed: 2026-10-16
References
- Hume, D. (1752). Of the balance of trade. In Political Discourses. Edinburgh: A. Kincaid & A. Donaldson.
- Goschen, G. J. (1861). The Theory of the Foreign Exchanges. London: Effingham Wilson.
- Alexander, S. S. (1952). Effects of a devaluation on a trade balance. IMF Staff Papers, 2(2), 263–278.
- Frenkel, J. A., & Johnson, H. G. (Eds.). (1976). The Monetary Approach to the Balance of Payments. London: George Allen & Unwin.
- International Monetary Fund. (2009). Balance of Payments and International Investment Position Manual (6th ed., BPM6). Washington, DC: IMF.