To buy foreign goods and services, the firms and individuals need to buy the currencies of the foreign countries. Similarly they need to purchase the currency of domestic country while paying for goods and services to foreigners.

The balance of payments is the method used by countries to monitor all their international transactions.

The Federal Reserve Board (FRB) defines a country's balance of payments as the record of transactions between its residents and foreign residents over a specified period. Any transaction that causes money to flow into a country is a credit to its BOP account, and any transaction that causes money to flow out is a debit.

The accounts are grouped into three major categories: current account, capital account, and financial account. The current account measures the flow of goods and services, the capital account consists of capital transfers and the acquisition and disposal of non-produced, non-financial assets; and the financial account records investment flows.

Let’s look at the components of each of these accounts.

Current Account

The current account is composed of four sub-accounts:

Merchandise and Services: Merchandise consists of all raw materials and manufactured goods bought, sold or given away. Services include tourism, transportation, engineering and business services, such as law, management consulting and accounting, fees from patents and copyrights on new technology, software, books and movies.

Income receipts: Foreign income derived from ownership of assets, such as dividends on holdings of stock and interest on securities.