INTERNATIONAL TRADE

A. GAINS FROM TRADE

International trade refers to the interchange of goods and services between and among countries. It also be
defined as the trade that takes place between two or more countries. It is essentially the exchange of
commodities on global scale. International trade arises because of the following reasons:
i) The production of different types of goods requires different kinds of resources. Such
resources. Such resources may not all be found in a country
ii) ifferent countries are endowed with different resources. ifferent regions of the world are
agricultural goods because of good climate and soils while other produce mineral resources.
Since agricultural countries need machinery to run their firms and process goods! such machinery
can be imported from industriali"ed nations.
iii) #ompetitive forces and the exercise of choice.
iv) Some goods cannot be produced efficiently as elsewhere and thus it makes more sense to
import it.
v) It may be better for the country to give up the production of a commodity and import it
instead! in order to specialise in something else.
vi) Shortage$at a time of high domestic demand for particular goods production may be unable to
meet this demand. In such a situation goods are imported to overcome the shortages.
Bilateral Trade$ This is the exchange of commodities between any two countries e.g. %enya and &ritain.
It is necessitated by differences technology and resources endowments existing between to countries.
Multilateral Trade$ This is the situation where a country conducts trade with more than one country. In
reality! international trade is carried out on the basis of multilateral arrangements rather than bilateral.
Visible trade $ this refers to the exchange of tangible goods between two or more countries
Invisible trade$ this is the exchange of intangible goods i.e. services such as tourism between two or
more countries.
Exprts! refers to the goods and services sold by a country to another country.
I"prts$ refers to the goods and services bought by a country from another country.
Advanta#es$I"prtan%e & Internatinal Trade
'a( Better Suppl) & Gds t*ru#* i"prtatin
Through international trade! a country may obtain goods which it does not produce through importation
from countries with surplus production or from where they can be produced at a cheaper costs! eg! less
developed countries find it to produce capital goods thus importing them from the industriali"ed
countries. This increases variety of goods available for consumers widening their choice and increasing
their satisfaction.
'b( L+er ,sts
' country can obtain goods which it could not grow or produce itself! and it can also obtain goods which it
could grow or produce ( but only at higher cost than in other countries.
%( -idens$expands "ar.et &r #ds and servi%es
International trade! by opening up the whole world for trading purposes! increases the si"e of the markets
for various goods. )oreign markets can be fully exploited to strengthen and widen a country*s market.
+roduction on a larger scale is then possible! allowing full advantage to be taken of economies of scale
such as increased efficiency in managerial skills! technological advancement! financial economies and
research economies to achieve greater output for the expanded foreign markets.
'%( Suppl) & %""dities durin# %ala"ities$Fa"ines %an be /revented$ international trade makes it
possible to provide urgently required goods and services to countries which may experience calamities as
drought! floods! earthquakes! or strikes. #ommodities such 's food and medicine can be rushed to the
areas affected! thus alleviating the problem. ,orld trade reduces the likelihood of famine and of other
results of shortages of supply! since it is possible to offset temporary domestic shortages by getting
additional supplies from abroad.
'd( A ,urb n Mnpl)
International trade is an obstacle to the development of monopolies. -ven if monopolies exist in a
country! their control over prices will be limited by the threat of foreign competition in form of large
multinational companies. Such companies tend to limit world competition by agreements between
themselves! and by their own power to absorb competitors.
'e( En%ura#e"ent & Internatinal ,peratin0 pea%e and understandin#
International trade leads to a greater degree of interdependence between sovereign states! and this should be
a factor making for international peace and friendly cooperation between nations. Trading countries develop
social! cultural! political and economical relationships. This leads to international peace necessary for social
co$existence! mutual understanding and strengthening of relationships.
'&(Exprtatin & %""dities leads t &ull utilisatin & resur%es$surplus commodities can be
exported to countries where they are not adequately available and where such surpluses are demanded.
This enables countries to exploit their resources fully because of increased market! e.g.! %enya produces
surplus tea which she exports to countries such as &ritain
'#(Frei#n ex%*an#e earnin#s$ when surplus commodities are produced and exported! foreign exchange
is earned. Surplus production which is not exported might go to waste. Thus! exporting of such goods
earns a country the much needed foreign exchange.
'*(Spe%ialisatin$ international trade brings about speciali"ation in the production of different
commodities which leads to lower costs of production. In this way! the world output of goods and
services increases.
'i(E%n"i% develp"ent$ international trade promotes economic development as it stimulates less
developed countries to compete with industrialised nations in the production of commodities.
'1(I"prved standards & livin#$ through international trade a country is able to wide import a wide
variety of goods and services. This gives a wide choice to the people which will raise the living standards.
'1(Mbilit) & &a%trs & prdu%tin$ International trade makes it possible for the mobili"ation of factors
of production such as land! labour capital as well as raw materials tp produce the most needed
commodities according to the market forces of demand and supply thus leading to optimal location of
resources.
'.(I"prved transprt$ international trade helps to improve transport facilities. This leads to an increase
in the volume of trade and variety of commodities traded! e.g. ! physical barriers as aero planes! trains and
ship can be used . #ommunication facilities such as telephones! telex! fax are today used to facilitate
trade! so orders can be placed through these facilities then commodity imported or exported as required.
'l(I"prved balan%e & pa)"ent$ due to export of goods and services! countries earn foreign exchange
which may be used to finance a deficit in the balance of payment
'"(In%reased #vern"ent revenue$ duties and taxes such as customs duties increase government
revenue which can be used to promote economic and social activities such as building schools! hospitals!
roads and dams.
Disadvanta#es & Internatinal Trade
a( Over relian%e n i"prted %""dities : .ver reliance on imported commodities can prove harmful
if the relationship between the trading nations goes sour. uring times of war trade is disrupted! thus the
supply of goods which were once relied upon no longer reach the country relying on them.
b( Ex*austin & resur%es$ /on$renewable resources such as mineral deposits become depleted as more
and more of them are being exploited! eg! 0ambia relies on export of copper. If copper deposits are
exhausted! then 0ambia*s economy will be affected.
c( 2a"pers #r+t* & in&ant industries$ international trade brings about stiff competition among
trading countries! therefore! infant industries find it difficult to compete with internationally well
established industries. Stiff competition in the international market tend to discourage newly established
industries which might end up closing down all together.
d( I"prtatin & *ar"&ul prdu%ts$ through international trade some harmful products might find their
way into a country eg! some harmful drugs such as banned pesticides! cocaine! mandrax and bad literature
might get into a country.
e( I"prtatin & in&latin$ standards of living of people depend on the level of inflation! when inflation
is low! the prices of commodities go down to the benefit of many people. This is because their purchasing
power for goods and services increase. 1owever! due to importation of commodities from countries
already suffering from inflation the cost of imported goods and services increase. This may cause
hardships to people who may find it difficult to buy commodities due to high prices! hence low standards
of living.
&( ,apital 3&li#*t4 ( foreign investments involve the movement of massive capital to produce goods and
services in a foreign country. The money which would have otherwise been used to invest in home
country is thus invested outside the country. If there is a decreased foreign investment from home
country.
#( Repatriatin & pr&its$ investment by foreigners in a home country is a healthy economic activity
since it promotes economic development in the country due to either economic or political reasons! then
there will be slowed economic development in the home country.
*( /liti%al bla%."ail$ a country that over$relies on international trade may be forced to adopt economic!
political and social policies that may be in conflict with its aspirations.
B. FREE TRADE AND /ROTE,TION
)ree trade refers to trade that is free from imposed restrictions suchas tariffs! quotas! total ban e.t.c. The
principle of comparative advantage shows that free trade and specialisation brings gains to the
participating countries. So long as a country has a comparative advantage in producing something it can
benefit from specialising in its production! and trading the surplus over home consumption for other
materials and products from abroad.
Advanta#es & Free Trade
2. #ountries can specialise and increase production safe in the knowledge that they can
export their surplus
3. 4esources are allocated efficiently
5. #ountries can export surpluses and import what they need
6. #ountries gain economies of scale from access to the world market
7. #ompetition from imports increases efficiency and limits the creation of monopolies
8. )ree movement of capital allows countries to develop their industries. )ree trade overcomes the
immobility of factors: it permits the free movement of the product of immobile factors so that countries
worldwide can benefit from an abundant factor endowment in any place.
9. +olitical links develop between countries.
:. 'ccess to the global market is essential for developing countries if they are to achieve economic
growth. Trade with the developed economies would give the developing nations a large market for their
goods and the opportunity to import new technology.
;. )irms could gain economies of scale and new techniques< competition would increase efficiency<
monopolies are avoided.
2=. +roduction for export helps to diversify the economy: it reduces dependence on what is often a single
crop sub>ect to disasters! like sudden frosts which halve the output of coffee.
/rte%tin
'll trading nations engage in some form of trade protection! as governments have to face political
pressures from powerful domestic interest groups. 't the same time they are often
reluctant to admit that they are imposing barriers! so they may avoid the formal measures
that would invite retaliation and invite censure from the ,orld Trade .rganisation ?,T.).
Instead they make use of a variety of devices to delay imports or make them more expensive. These
include cumbersome import procedures with complicated documentation or @safety measures@ with a
dubious safety value.
't the same time the more formal measures still survive! and are employed by individual
countries and regional groups such as the -uropean Anion. The main such measures are:
import tariffs! also known as customs duties! which are taxes imposed on goods when
they enter a country or one of a group of countries such as the -A! which contrast with
import quotas! which are quantitative restrictions on the import of goods.
The belief that free trade ?trade free from imposed restrictions) should be encouraged as
much as possible is linked closely to the theory of comparative cost advantage.
ARG5MENTS IN FAVO5R OF T2E 5SE OF /ROTE,TIONIST
MEAS5RES$REASONS FOR RESTRI,TING IM/ORTS
i) T %rre%t balan%e & pa)"ents de&i%it$ when a countries payment exceed her receipts in the
international transactions! the result is a balance of payments deficit. This means that more
money goes out of the country than it receives. Tariffs ! quotas! total ban and other restrictive
measures are used to discourage imports and promote exports thus correcting a deficit balance of
payment.
NB &alance of payments is not only concerned with imports but also with exports! and the
government will have to consider what effect the imposition of protectionist measures by a
country will have on that countryBs exports.
ii) T prte%t 3in&ant4 industries$ These are those industries which are being introducedCestablished
industries in a country where the industry has not previously been present. @Infant@ industries
need protection from foreign competition to prevent them from collapse. The absence of external
economies makes the costs of production high for new industries. Such industries cannot
withstand competition from well established foreign industries! if these industries are not
protected from international competition! they may end up closing down
iii) T pr"te e"pl)"ent & resur%es$ Import restrictions measures! such as tariffs tend to shift
demand away from imports to the home produced goods. Income is directed away from foreign
exports and towards domestic producers. 's the demand for home produced goods increases!
more resources will be employed to produce them. .n the other hand! if there is already full
employment at home! such measures will tend to be inflationary in their effects.
iv) To protect key industries for National Security
%ey industries! such as agriculture and those producing goods which are important for the defence of
the country! must be maintained for security reasons. iversity of industries is important to a country!
as it makes it independent of foreign supplies which may be >eopardi"ed in the event of war.
v) T diversi&) industrial #r+t*$ Industrial diversification for economic growth! development and
stability of a country. If new and diversified industries producing different commodities cannot come
up due to international trade! it would meant hat one country will rely on one or a few key industries.
This is not desirable for economic growth development
vi) T prte%t .e) industries are +ell establis*ed and strate#i% industries &r a %untr). Such
industries promote faster economic growth and development and lead to establishment of other
industries. They may also promote agricultural! banking! transport and tourism! therefore! they
should be protected from closing down
vii) T prte%t de%linin# industries$ certain industries in %enya! such as the textile industry is on the
decline. They are faced with stiff competition from second$hand clothes imported from
developed countries! hence! there is need for the %enyan government to levy taxes on second
hand clothes. 'ny other country participating in international trade can protect her industries in
the same way
viii) /rte%tin a#ainst du"pin#$
)oreign industries may choose to dump their inferior or sub$standard goods in a country.
umping implies selling in a foreign market at prices below what is charged at home.
+rotection measures are needed to protect a country against the dumping of cheap and inferior
foreign goods. @umping@ means the application to international trade of the methods of a
discriminating monopoly whereby goods are sold abroad at a lower price than at home. This is done
in order to avoid swamping the home market with a surfeit of goods which would bring down home
prices! and to kill off foreign competition by undercutting it on its own markets. umping is an
unfair trading practice! and for that reason industries fearing competition from dumped goods ask for
tariff protection. Dany industrialists begin to complain if they have to face competition from foreign
goods which are cheaper than their own. The home producers may simply be inefficient. 'lso! when
dumping takes place! the imposition of protective duties may be too slow a weapon! since by the
time the new duties have been introduced! the dumped goods may already be in the country.
ix( I"prve"ent & t*e Ter"s & Trade
The imposition of import duties may lead to an improvement in the terms of trade! particularly
where the goods taxed are in inelastic supply and elastic demand.
Dan#ers & Trade /rte%tin$Disadvanta#es
The case against import controls is based on the following factors.
'a( Bene&its & Free Trade Based n ,"parative ,st Advanta#e
It can be argued that multinational enterprise! unemployment and speciali"ed production represent
modifications and imperfections only! and do not change the fundamental truth and importance of the
benefits to be derived from international speciali"ation and trade. -fforts should be made to reduce the
harmful effects of these ( including efforts to reduce the monopoly power of large multinationals ( and to
increase trade! not to interfere with it.
'b( /ssible Internatinal Retaliatin
,hen a country imposes restrictions on imports from other countries! the other countries can react by
similarly imposing restrictions on imports from the former country. If all countries sought to reduce! and
impose barriers against! imports! total trade and production would fall! and unemployment would increase
in all countries. The spread of protectionism would increase unemployment instead of reducing it.
'%( Redu%tin in Industrial E&&i%ien%) and prdu%tin & l+ 6ualit) #ds
#ompetition is the main incentive to business efficiency. +rotecting domestic industry against foreign
competition would make firms less able to compete in world markets. The longer controls lasted! the more
they would be needed! and the country would lose the variety of products provided by imported goods. Its
standard of living would fall with this loss of choice! as increasingly inefficient firms required more and
more resources to produce less and less. The protected local industries may end up producing low quality
commodities due to lack of competition. The local consumer is therefore denied the chance of en>oying high
quality goods which might otherwise come from the other countries.
d( 2i#* pri%es &r L%all) /rdu%ed ,""dities
The protected infant local industries may not en>oy economies of scale due to their small si"es! they
therefore incur high production costs for their products. The high production costs lead to high prices for
their commodities
e( /ssible E"er#en%e & Mnplies! +rotectionism may lead to emergence of monopolies! this may
give rise to problems associated with monopolies! and these include being insensitive to the customer
demands! overcharging and provision of low quality products.
#( Dan#er & t*e Need &r /erpetual /rte%tin! The protected infant industries have a tendency of
remaining young! this means that these industries remain calling for continued protection with all its
inherent problems.
*( Less ,nsu"er ,*i%e! Trade restrictions implies that there would be fewer goods and services that
consumers can choose from! this in turn leads to low standards of living for such consumers.
,. MET2ODS OF /ROTE,TION
' country can restrict the freedom of international trade by using the following methods:
7. Tari&&sC%ust" duties
Tariffs are taxes on imported goods and so of course they raise money for the government. The ob>ect is
to raise the cost of the imported goods so that importers have to raise prices or accept reduced profits. The
imports thus suffer a competitive disadvantage compared with home produced substitutes. The tariff
raises the price paid for the imported good by the domestic consumer and reduces the quantity purchased.
Thus domestic producers supply more to the market! and foreign suppliers provide less than if there were
no tariff. #ustoms duties may be imposed by a specific duty of so much per item or per tonne or ad
valorem ?by value). Specific duties work best for goods of low value and high weight! such as iron. 'd
valorem duties obviously have more impact as goods increase in value! so they are best applied to items
like >ewellery and those whose prices change often.
8. 9utas
Euotas are restrictions on the quantity of a product which can be imported. ,hile the purpose of
protective customs duties is to restrict the import of goods by making them more expensive to the home
consumer! import quotas lay down the exact quantity of a commodity which may be imported in a given
period of time. Import quotas may! but need not! be accompanied by customs duties. If they are! it means
that the limited amount of goods which may be imported is sub>ect to the duty as well.
:. E"bar#es$Ttal ban
'n embargo is a total ban on imports or exports! usually applied for political reasons. 'n example is the
A/ embargo on exports of armaments to Iraq and on oil exports from Iraq.
;. Exprt Subsidies and Bunties
These can be of the visible type! where a bounty is paid to exporters by the government
according to how much they send abroad. ,T. rules generally forbid bounties! so hidden
subsidies tend to be provided instead. )or example! exporters get government insurance
against political and commercial risks at very low rates! tax concessions on equipment used
for making exports and help with borrowing to finance export production.
<. Nn!tari&& Barriers r ad"inistrative restri%tins
This refers to multitude of measures applied to restrict imports! especially where countries cannot use
tariffs and quotas because they belong to ,T. or a free trade area. They include oppressive safety
measures! like the AS' requirement for destructive car tests! which would require the whole annual output
of a small specialist manufacturer to be crashed. The term is also applied in trade liberali"ation to refer to
all restrictive measures except tariffs. This is because tariffs are the only measure to be visible and
measurable with accuracy. 'greements to reduce tariffs are pointless if duties are replaced by other
measures which are difficult to police.
=. Ex%*an#e ,ntrl
#ontrol is enforced in many countries by requiring all buying and selling of foreign exchange to be done
through the central bank. The government can then allocate foreign exchange to whichever activities it
considers should have priority. This is effectively the same as a quota and is sub>ect to the same dangers.
Fovernments can avoid some of the problems by auctioning
off foreign exchange! as was done in /igeria. The amount released to auction is determined
by the state of the balance of payments. -xchange and capital controls! however may cause economic
damage and may also be ineffective in achieving what they were intended to achieve! and abolished them
either completely or in part.
TERMS OF TRADE
Terms of trade can be defined as the rate at which a country*s goods ?exports) exchanges against those of
other countries ?imports). To calculate terms of trade! index of average prices of goods exported from a
country in a particular year is taken as base year and expressed as 2==. Then the average prices of goods
exported in subsequent years are worked out as the percentage of the average prices dating the base year.
This may be computed using exported price index and import price Index as shown in the following in the
following equation:
Terms of tradeG price index exports
+rice index of imports
.4
Terms of trade G export price index
Import price index
The total of a country*s export earnings depends on both volume and the prices of such exports. Incase
the price of the export decline! the country may have to increase the quantities exported in order to at least
retain the earnings at the same level. -qually the total amount spent on imports depends both on the
quantities and price of such imports! a country may have to increase the volume of her exports in order to
get the same volume of imported goods as she was getting before. There is therefore a relationship
between what a country exports and what she exports. The relationship may be expressed by what is
referred to as terms of trade.
IM/ORTAN,E OF TERMS OF TRADE
If the prices of a country*s exports rise! while those of her imports are constant! or declining! terms of
trade are said to be favourable or improving. This is a healthy situation because a country obtains more
foreign exchange in exports than it pays for her imports
)avourable terms in trade imply that:
i) ' country can get more imports with the same quantity of exports
ii) There is an increase in national income in the country and hence! high standards of living
iii) There is an improvement in balance of payments
.n the other hand! if prices of a country*s exports decline! or remain constant! while those of her imports are
rising! terms of trade are said to be unfavourable or deteriorating. This is an unhealthy situation because a
country obtains less foreign exchange from exports than it pays for imports
Anfavourable trade implies:
i) ' given volume of exports will now exchange for smaller volume of imports
ii) There is less foreign exchange earnings from exports! leading to reduced domestic earnings
iii) There will be balance of payments problems ?deficit)
Balan%ed Ter"s O& Trade
If the ratio of terms of trade equals one ?2) it means that the average prices of import commodities is
equal to average prices of commodities. ' country which experiences balances terms of trade has its
domestic prices of goods and services competing at equal price level with foreign goods and services.
1owever! this situation is a rare one since different countries of the world have different levels of natural
and man made resources
,A5SES OF ,2ANGES IN TERMS OF TRADE
epending on the prices and volume of exports! and imports traded! a country*s terms of trade can either be
favourable or unfavourable. Thus! terms of trade may fluctuate upwards or downwards
)actors leading to unfavourable terms of trade
i) Increase in supply of exports will decrease their prices! this will cause unfavourable terms of
trade in the exporting industry
ii) ' fall in demand for a country*s export will lead to a fall I export prices! causing
unfavourable terms of trade in the exporting countries
iii) 'n increase in demand for imports will lead to an increase in price of those imports! leading
to unfavourable terms of trade in importing countries
iv) +olitical instability may affect the production of exports! leading
v) to a fall in volume of exports hence! unfavourable terms of trade.
)actors leading to )avourable terms of trade
i) ecrease in supply of exports will lead to an increase in their prices! this will lead to an
improvement in terms of trade in lead to a fall in their prices! in the exporting country
ii) 'n increase in demand for a country*s exports will led to an increase in the price of those
exports! this will lead to favourable terms in terms of trade in the exporting countries
iii) ' fall in demand for imports! may lead to a fall in their prices! hence bringing about an
improvement of trade in the exporting country*s trade
iv) ' high supply of imported goods leads to a fall in their price! leading to favourable terms of
trade in the importing country.
' country may experience favourable remain constant or increase terms of trade if
a) prices of imports decline while those of exports either remain constant or increase
b) prices of imports decline while those of exports increase
c) price of imports decline while those of exports increase
d) +rice of imports remain constant while those exports increase
#onversely! a country*s terms of trade would be unfavourable if:
a) prices of imports increase while those of exports decline
b) prices of exports decline while those of imports increase
c) prices of imports remain constant while those of exports decline
d) prices of exports remain constant while those of imports increase
Reasns &r di&&eren%es in t*e ter"s & trade bet+een %untries
There are a number of reasons that account for differences in terns of trade between countries. Some of
these reasons are discussed below:
a( Nature & %""dit) bein# exprted
/ormally! the price of primary products tends to be lower to those of manufactured goods. ' country
whose main export is raw materials such as unprocessed agricultural products is likely to experience
unfavourable terms of trade.
b( Nature & t*e %""dit) bein# i"prted
Some commodities such as manufactured goods higher prices compared to others in the world market. '
country imports such expensive goods may experience adverse terms of trade while one that imports cheap
raw materials may experience favorable terms of trade.
%( De"and &r a %untr)4s exprts
,here there is an increase in demand for a country*s exports in the world market! such as a country to
experience favourable terms of the world! such a country is likely to export to experience favourable
terms of trade. .n the other hand! if demand for a country*s exports decline! she may experience
unfavourable terms of trade.
d( Existin# +rld e%n"i% rder
ue to their strong bargaining power! industriali"ed countries tend to dominate the decision making in t
he international market. International prices therefore tend to favour products from these countries. 's a
result of this! they may have favourable terms of trade while the less dev eloped countries may have
deteriorating terms of trade.
e( Ttal 6ualit) supplied
In a situation where a commodity is supplied by many countries into the world market! its supply may be
very high and this may tend to depress its price. ' country relying on exportation of such a product may
experience unfavourable terms of trade. .n the other hand a country that relies on exportation of a
commodity that is in short supply in the world market may experience favourable terms of trade.
BALAN,E OF TRADE
&alance of trade is the difference between the value of visible imports. &alance of trade is also referred to
as balance of visible trade?H $D)
If the value of visible exports exceeds the value of visible exports! balanced of trade is said to be
&avurable
eg! if a country*s total visible exports amounted to Sh. 57 billion while the value of her total imports are
Sh. 38 billion then the country*s favourable balance of trade can be obtained as follows
&alance of trade G -xports ?visible)$ imports ?visible)
G57!===!===!===$ 38!===!===!===
surplus G Shs G ;!===!===!===
If the value of visible imports exceeds the value of visible exports balance of trade is said to be
un&avurable
eg! if a country*s total visible imports amounted to Shs. 52 billion while her visible exports amounted to
Shs. 38 billion! then the country*s unfavourable balance of trade can be obtained as follows
&alance of trade G exports ?visible)$ imports?visible)
G38!===!===!===$52!===!===!===
eficit G 7!===!===!===
Balan%e & pa)"ents
&alance of payment touches on all economic transactions that take place between one country and the rest
of the world over a period of one year. &alance of payments is the difference between all the
receipts?inflow) of foreign currency and payment ?outflows) of foreign currency
The balance of payments of a country is the systematic record of all its receipts and payments in
international transactions in a given year. The balance of payments account is structured into two parts
i( T*e %urrent a%%unt
In the current account of balance of payments! the following transactions are recorded. The difference
between visible and invisible imports! The difference between invisible imports and invisible export
?trade in service)
ii( T*e %apital a%%unt
In the capital account of balance of payments! the following transaction are recorded
/et short$term private inflows! /et long$term private inflows! /et short$ term government ?official)
capital inflows! /et long term government capital inflows
If the sum of the four transactions above is positive ?I)! then capital account is said to have a surplus.
#onversely! if the sum of the four transactions is negative ?$)! then capital account is said to be in deficit.
N$B: In developing countries like %enya! current account in most cases has a deficit! while capital
account is in surplus. If surplus in the capital account exceeds the deficits in deficit account! the balance
of payments is said to be in surplus. #onversely! if the surplus in the account is less is said to be to be a
deficit ?$)
The balance of payments account has the debit side and the credit side. The principal items on the credit
side include:
2. Jisible exports?receipts from exports of goods)
3. Invisible exports?receipts from exports of services e.g tourism banking! insurance)
5. Transfer receipts in the form of gifts received from foreigners.
6. &orrowings from abroad and investments foreigners in the country
7. .fficial sale of reserve assets including gold to foreign countries and international institutions.
The principal items on the debit side include:
2. Jisible imports?payments for imports of goods)
3. Invisible imports?payments for imports of services)
5. Transfer payments to foreigners in the form of gifts
6. Koans to foreign countries! investments by residents in foreign countries and debt repayments to
foreign countries.
8. .fficial purchase of reserve assets including gold from foreign countries and international
institutions.
If total receipts from foreigners on the credit side exceed total payments to foreigners on the debit side!
the balance of payments is said to be &avurable. .n the other hand if total payments to foreigners on the
debit side exceed total receipts from foreigners on the credit side! the balance of payments is said to be
un&avurable.
DISE95ILIBRI5M IN BALAN,E OF /A>MENTS
' disequilibrium in the &.+ of a country may be either a deficit or surplus. ' deficit or surplus in &.+
of a country appears when its autonomous receipts ?credits) do not match its autonomous payments
?debits). If autonomous credit receipts exceed autonomous debit payments! there is a surplus in the &.+
and the disequilibrium is said to be favourable. .n the other hand! if autonomous debit payments exceed
autonomous credit receipts! there is a deficit in the &.+ and disequilibrium is said to be unfavourable or
adverse.
,A5SES OF DISE95ILIBRI5M IN T2E BALAN,E OF /A>MENTS
There are many factors that may lead to a &.+ deficit or surplus:
7. Te"prar)$seasnal ,*an#es 'r Dise6uilibriu"(. There may be a temporary disequilibrium
caused by random variations in trade! seasonal fluctuations! the effects of weather on agricultural
production! etc. eficits or surpluses arising from such temporary causes are expected to correct
themselves within a short time.
8. Funda"ental Dise6uilibriu"? )undamental disequilibrium refers to a persistent and long$run &.+
disequilibrium of a country. It is a chronic &.+ deficit! according to ID). It is caused by such dynamic
factors as: ?i)#hanges in consumer tastes within the country or abroad which reduce the countryBs exports
and increase its imports.
?ii)#ontinuous fall in the countryBs foreign exchange reserves due to supply inelasticities of exports
and excessive demand for foreign goods and services.
?iii)-xcessive capital outflows due to massive imports of capital goods! raw materials! essential
consumer goods! technology and external indebtedness.
?iv)Kow competitive strength in world markets which adversely affects exports.
?v)Inflationary pressures within the economy which make exports dearer.
:. Stru%tural ,*an#es 'r Dise6uilibriu"(. Structural changes bring about disequilibrium in &.+ over
the long run. They may result from the following factors:
?a)Technological changes in methods of production of products in domestic industries or in the
industries of other countries may lead to changes in costs! prices and quality of products.
?b)Import restrictions of all kinds bring about disequilibrium in &.+.
?c)eficit in &.+ also arises when a country suffers from deficiency of resources which it is
required to import from other countries.
?d)isequilibrium in &.+ may also be caused by changes in the supply or direction of long$term
capital flows. Dore and regular flow of long$term capital may lead to &.+ surplus! while an irregular and
short supply of capital brings &.+ deficit.
;. ,*an#es in Ex%*an#e Rates in t*e &r" & ver!valuatin & &rei#n %urren%). ,hen the value of
currency is higher in relation to other currencies! it is said to be overvalued. .n the other hand when the
value of currency is lower in relation to other currencies! it is said to be undervalued currency.
.vervaluation of the domestic currency makes foreign goods cheaper and exports dearer in foreign
countries. 's a result! the country imports more and exports less of goods. There is also outflow of
capital. This leads to unfavourable &.+. .n the contrary! undervaluation of the currency makes &.+
favourable for the country by encouraging exports and inflow of capital and reducing imports.
<. ,)%li%al Flu%tuatin 'r Dise6uilibriu"( in business a%tivit). ,hen there is depression in a country!
volumes of both exports fall drastically in relation to other countries. &ut the fall in exports may be more
than that of imports due to decline in domestic production. Therefore! there is an adverse &.+ situation.
.n the other hand! when there is boom in a country in relation to other countries! both exports and
imports may increase. &ut there can be either a surplus or deficit in &.+ situation depending upon
whether the country exports more than imports or imports more than exports. In both the cases! there will
be disequilibrium in &.+.
=. ,*an#es in Natinal In%"e. If the national income increases! it will lead to an increase in imports
thereby creating a deficit in its balance of payments! other things remaining the same. If the country is
already at full employment level! an increase in income will lead to inflationary rise in prices which may
increase its imports and thus bring disequilibrium in the balance of payments.
@. /ri%e ,*an#es'In&latin r De&latin(. If there is inflation in the country! prices of exports increase.
's a result! exports fall. 't the same time! the demand for imports increases. Thus increase in export
prices leading to decline in exports and rise in imports results in adverse balance of payments.
A. Sta#e & a ,untr)4s E%n"i% Develp"ent. If a country is developing! it will have a deficit in its
balance of payments because it imports raw materials! machinery! capital equipment! and services
associated with the development process and exports primary products. The country has to pay more for
costly imports and get less for its cheap exports. This leads to disequilibrium in its balance of payments.
B. ,apital Mve"ents. &orrowing and lending or movements capital by countries also result in
disequilibrium in &.+. ' country which gives loans and grants on a large scale to other countries has a
deficit in its &.+ on capital account. If it is also importing more! as is the case with the AS'! it will have
chronic deficit. .n the other hand! a developing country borrowing large funds from other countries and
international institutions may have a favourable &.+. &ut such as possibility is remote because these
countries usually import huge quantities of food! raw materials! capital goods! etc and export primary
products. Such borrowings simply help in reducing &.+ deficit.
7C. /liti%al ,nditins & a %untr). +olitical instability in a country creates uncertainty among foreign
investors which leads to the outflow of capital and retards its inflow. This causes disequilibrium in &.+
of the country. isequilibrium in &.+ also occurs in the event of war or fear of war with some other
country.
IM/LI,ATIONS OF A DISE95ILIBRI5M IN T2E BALAN,E OF /A>MENTS TO T2E
E,ONOM> ' -2ET2ER A DEFI,IT OR S5R/L5S(
' deficit in the combined current and capital accounts is regarded as undesirable for the country
because the deficit has to be covered by borrowing from abroad or attracting foreign exchange or capital
from abroad. This may require paying high interest rates. There is also the danger of withdrawing money
by foreigners. 'n alternative may be to draw on the reserves on the reserves of the country which may
also lead to a financial crisis. Doreover the reserves of a country being limited! they can be used to pay
for &.+ deficit up to a limit.
1owever! it is beneficial for a country to have a current account deficit even if it equals capital
account surplus in &.+. In the short$run! the country may benefit from a higher level of consumption
through import of goods and consequently a higher standard of living. &ut the excess of imports over
exports may be financed by foreign investments in the country. These may lead to increased production!
employment and income in the country. In the long$run! foreign investors may purchase large assets in
the country and thus adversely affect domestic industry as is the case with D/#s ?multinational
corporations).
The current account deficit in &.+ of a country may have either good or bad effects depending
on the nature of an economy.
a) In a country where domestic industries are rapidly growing and it has current account &.+
deficit. These industries offer a high rate of return on their investment. This would! in return!
attract foreign investments. 's a result! the country would have a capital account surplus due to
the inflow of capital and a current account deficit. This current account deficit is good for the
economy. /o doubt the external debt of the country increases! but this debt is being utili"ed to
finance the rapid growth of the economy. The real burden of this debt will be very low because it
can be rapid out of higher income in the future.
b) .n the contrary! a country having an inefficient and unproductive domestic industry will be
adversely affected by its current account &.+ deficit. The country borrows from abroad to
finance the excess of spending over consumption. To attract foreign borrowings! the country will
have to pay high interest rates. These will increase the money burden of the debt. The real burden
of the debt will also increase because of the low productive capacity of domestic industries. If the
current consumption is being financed by foreign borrowings! the wealth of the economy will
decline. This! in turn will lead to either a reduction in domestic expenditure or a change in
government policy so as to control the rising debt.
.n the other hand! if foreign borrowings are being used to finance real investment! the current account
&.+ deficit will be beneficial for the economy. ' higher rate of return on real investment than the interest
on foreign borrowings would increase the countryBs wealth over time through rise in its national income.
Thus a current account &.+ deficit is not always undesirable for a country.
MEAS5RES TO ,ORRE,T DEFI,IT IN BALAN,E OF /A>MENTS
,hen there is a deficit in the balance of payments of a country! ad>ustment is brought about automatically
through price and income changes or by adopting certain policy measures like export promotion!
monetary and fiscal policies! devaluation and direct controls.
7.Ad1ust"ent t*ru#* Ex%*an#e Depre%iatin '/ri%e E&&e%t(
Ander flexible exchange rates! the disequilibrium in the balance of payments is automatically solved
by the forces of demand and supply for foreign exchange. 'n exchange rate is the price of a currency
which is determined! like any other commodity! by demand and supply. LThe exchange rate varies with
varying supply and demand conditions! but it is always possible to find an equilibrium exchange rate
which clears the foreign exchange market and creates external equilibrium.M This is automatically
achieved by depreciation of a countryBs currency in case of deficit in its balance of payments.
epreciation of a currency means that its relative value decreases. epreciation has the effect of
encouraging exports and discouraging imports. ,hen exchange depreciation takes place! foreign prices
are translated into domestic prices. Suppose the dollar depreciates in relation to the pound. It means that
the price of dollar falls in relation to the pound in foreign exchange market. This leads to lowering of the
prices of A.S exports in &ritain and raising of prices of &ritish imports in the A.S. ,hen import prices are
higher in the A.S the 'mericans will purchase less goods from the &ritish. .n the other hand! lower
prices of A.S exports will increase exports and diminish imports! thereby bringing equilibrium in the
balance of payments.
8.Devaluatin & %urren%) r Expenditure!S+it%*in# /li%)
' government may devalue her currency in order to make her exports cheaper and competitive with
the world market. This therefore will lead to conservation ?savings) of foreign exchange and increase
earnings of foreign exchange. evaluation raises the domestic price of imports and reduces the foreign
price of exports of a country devaluing its currency in relation to the currency of another country.
evaluation is referred to as expenditure switching policy because it switches expenditure from imported
to domestic goods and services. ,hen a country devalues its currency! the price of foreign currency
increases which makes imports dearer and exports cheaper. This causes expenditures to be switched from
foreign to domestic goods as the countryBs exports rise and the country produces more to meet the
domestic and foreign demand for goods with reduction in imports thus correcting balance of payments
deficit.
:. Restri%tin & i"prts CDire%t ,ntrls ai"ed at li"itin# t*e vlu"e & i"prts.
' country may take measures such as imposing heavy import dutiesCtariffs! fixing import quotas and
imposing total ban to restrict the import of undesirable or unimportant items. 't the same time! it may
allow imports of essential goods duty free or lower import duties! or fix liberal import quotas for them.
)or instance! the government may allow free entry of capital goods! but impose heavy import duties on
luxuries. Import quotas are also fixed and the importers are required to take license from the authorities in
order to import certain essential commodities in fixed quantities. In these ways! imports are reduced in
order to correct an adverse balance of payments. The government also imposes exchange controls.
-xchange controls have a dual purpose. They restrict imports and also control and regulate the foreign
exchange. ,ith reduction in imports and control of foreign exchange! visible and invisible imports are
reduced. #onsequently! an adverse balance of payments is corrected.
;.Ad1ust"ent t*ru#* ,apital Mve"ents
' country can use capital imports to correct a deficit in its balance of payments. ' deficit can be
financed by capital inflows. ,hen capital is perfectly mobile within countries! a small rise in the
domestic rate of interest brings a large inflow of capital. The balance of payments is said to be in
equilibrium when the domestic interest rate equals the world rate. If the domestic interest rate is higher
than the world rate! there will be capital inflows and the balance of payments deficit is corrected.
<.Ad1ust"ent t*ru#* In%"e ,*an#es
Fiven the foreign exchange rate and prices in a country! an increase in the value of exports! causes an
increase in the incomes of all persons associated with the export industries. These! in turn! create demand
for other goods and services within the country. This will raise the incomes of persons engaged in the
latter industries and services. This process will continue and the national income increases by the value of
the multiplier.
=. Exprt /r"tin and I"prt substitutin
' country may promote her exports through measure such as producing quality products! by reducing
exports through increased production and productivity! and by better marketing! giving to export
producers export compensation and reducing taxes on exports. They can also be increased by a policy of
import substitution. It means that the country produces those goods which it imports. In the beginning!
imports are reduced but in the long run exports of such goods start. 'n increase in exports causes the
national income to rise by many times through the operation of the foreign trade multiplier. The foreign
trade multiplier expresses the change in income caused by a change in exports. Altimately! the deficit in
the balance of payments is removed when exports rise faster than imports.
@.Expenditure!Redu%in# pli%ies
' deficit in the balance of payments implies an excess of expenditure over income. To correct it!
expenditure and income should be brought into equality. )or this expenditure reducing monetary and
fiscal policies are used. ' contractionary or tight monetary policy relates to cut in interest rates to reduce
money supply and a contractionary fiscal policy relates to reduction in government expenditure and or
increase in taxes. Thus expenditure reducing policies reduce aggregate demand through higher taxes and
interest rates! thereby reducing expenditure and output. The reduction in expenditure and output! in turn!
reduces the domestic price level. This gives rise to switching of expenditure from foreign to domestic
goods. #onsequently! the countryBs imports are reduced and the balance of payments deficit is corrected.
A.See.in# &inan%ial assistan%e internatinall)
' government may seek financial institutions ?ID)! ,orld bank) which may come in form of loans!
grants or aid. Such funds may be used to finance the deficit in the balance of payments
B. 5tiliDatin & a %untr)4s &rei#n reserves
' country may use the accumulated foreign exchange reserves to correct her balance of payments
deficit.