Balance of Payments

The Balance of Payments

The balance of payment is a statement

showing all of a nation’s transactions
with the rest of the world for a given
period. It includes purchases and sales
of goods and services, gifts,
government transactions, and capital
movements.
Balance of Payments

 Balance of Payment Accounts

– The accounts in which a nation records
its international trading, borrowing, and
lending.
– Current account
– Record of international receipts and
payments—current account balance equals
exports minus imports, plus net interest
and transfers received from abroad.
Balance of Payments

– Capital account
– Record of foreign investments in India
minus Indian investments abroad
– Official settlements account
– Record of the change in Indian official
reserves
 Official reserves
 The government‘s holdings of foreign
currency
US Balance of Payments
US Balance of Payments
US Balance of Payments
Balance of Payments : Individual Analogy

– An individual‘s current account records the income

from supplying the services of factors of production
and the expenditures on goods and services.
– An example: In 2000, Joanne
• Worked and earned an income of $25,000
• Had investments that paid an interest of $1,000
• Her income of $25,000 is analogous to a country‘s
export
• Her $1,000 of interest is analogous to a country‘s
interest from abroad
 Balance of Payments : Individual Analogy
– Joanne:
• Spent $18,000 buying goods and services to
consume
• Bought a car, which cost her $60,000
• Joanne‘s expenditure totaled $78,000
• Her expenditure is analogous to a country‘s
imports
– Her current account balance was $26,000 –
$78,000, a deficit of $52,000
Balance of Payments : Individual Analogy

 To pay the $52,000 deficit, Joanne

borrowed $50,000 from the bank and used
$2,000 that she had in her bank account.
 Joanne‘s borrowing is analogous to a
country‘s borrowing from the rest of the
world.
 The change in her bank account balance is
analogous to the change in the country‘s
official reserves.
The Balance of Payments

 A country’s current account is the sum of

its:
– net exports (exports minus imports),
– net income received from investments
abroad, and
– net transfer payments from abroad.
 Exports earn foreign exchange and are a
credit (+) item on the current account.
Imports use up foreign exchange and are
a debit (–) item.
The Balance of Payments

 The balance of trade is the difference

between a country’s exports and
imports of goods.
 A trade deficit occurs when a country’s
exports are less than its imports.
The Balance of Payments

 Investment income consists of holdings

of foreign assets that yield dividends,
interest, rent, and profits paid to Indian
asset holders (a source of foreign
exchange).
 Net transfer payments are the difference
between payments from India to
foreigners and payments from foreigners
to India.
The Balance of Payments
 The balance on current account consists of net
exports of goods, plus net exports of services, plus net
investment income, plus net transfer payments. It
shows how much a nation has spent relative to how
much it has earned.
 For each transaction recorded in the current account,
there is an offsetting transaction recorded in the
capital account.
– A debit records a transaction increasing assets or reducing
liabilities.
– A credit records a transaction reducing assets or increasing
liabilities.
Balance of Payments Accounts : Example
1. Current Account
2. Merchandise
3. Exports +683
4. Imports -1,030
5. Balance of trade -347
6. Services
7. Exports +277
8. Imports -197
9. Balance of services +80
10. Balance of goods and services -267
11. Net invesment income -25
12. Net transfers -47
13. Invest. trans. balance -72
14. Balance on current account -339
15. Capital account
16. Capital inflows +751
17. Capital outflows -373
18. Balance on capital account +378
19. Current and capital balance +39
20. Statistical discrepancy -36
21. Official transaction account +3
22. Totals 0
Double Entry Bookkeeping in BOP

 In recording a nation‘s international

transactions, the accounting procedure
known as double-entry bookkeeping is
used.
 Each international transaction is
recorded twice, once as a credit and
once as a debit of an equal amount.
BOP –Double Entry Bookkeeping Example - 1
BOP –Double Entry Bookkeeping Example - 2
BOP –Double Entry Bookkeeping Example - 3
 India’s BOP : The Pre-1991 Period

 When India became independent, it had surplus ‗sterling balance‘ of

Rs. 1733 crores due to increased purchasing by UK during WW-II, to
meet their war requirements
 During the first plan period, the overall Balance of Trade was Rs.
541.9 crores, with a current account deficit of Rs. 42.3 Crores.
 Bimal Jalan divides the period after 1956-57 into three sub periods
– Period – I (1956-57 to 1975-76)
– Period – II (1976-77 to 1979-80)
– Period –III (1980-81 to 1990-91)
– Jalan used the following two criteria as a rough measure of the
BOP problem in a particular year –
 The current account deficit was more than 1 per cent of GDP
and
 The foreign exchange reserves were less than necessary to
cover three months‘ imports
 India’s BOP : The Pre-1991 Period

– Period I and III were characterized by persistent balance of payments problem (although
in some years during these periods, the reserves were sufficient to cover more than 3
months imports, but Current Account deficit remained above 1% of GDP during these
periods)
– Period-II saw a substantial improvement in the balance of payments (CAD of around
0.6% of GDP) and foreign exchange reserve position (worth about 7 months imports)
– In periods I and II, the entire deficit was financed through inflows of concessional
assistance and this kept the debt servicing burden low.
– In contrast, a substantial part of the deficit had to be financed through non-concessional
loans obtained on market related terms during period-III.
– Moreover, in contrast to period-I, the macroeconomic policy in period-III was highly
expansionary.
 The combined fiscal deficit of the Centre and States which was less than 6% of GDP
in period-I rose considerably in Period-III and reached 12.1% in 1990-91.
– Further, during period-III, due to import liberalization, the imports over the second half of
1980s (1985-86 to 1990-91) grew at an average annual rate of 17%, and in absence of
commensurate growth in exports, the higher growth of the domestic economy was
financed by external loans on hard terms.
India’s BOP : Since 1991

 The BOP situation has improved remarkably post 1991

 In three consecutive years 2001-02, 2002-03 and 2003-04, there was surplus on current
account.
 The reasons for satisfactory balance of payments situation in post-reform period are as follows:
– High earnings from invisibles (primarily software exports)
– Rise in External Commercial Borrowings
– Non-Resident Deposits
– Role of Foreign Investment
BOP disequilibrium
 The balance of payments of a country is said to be
in equilibrium when the demand for foreign
exchange is exactly equivalent to the supply of it.
 The Balance of Payment is regarded as being in
disequilibrium when it shows either a surplus or
deficit.
– There will be a deficit in the balance of payments when
the demand for foreign exchange exceeds its supply, and
– There will be a surplus when the supply of foreign
exchange exceeds the demand.
 A number of factors may cause disequilibrium in the
balance of payments.
Causes (types) of the BOP disequilibrium

 Development Programmes
– The direct impact of large scale development expenditures is seen in
increase of the purchasing power, aggregate demand and prices.
– This results in large scale imports.
– This phenomenon is common in developing countries where large scale
import of capital goods needed for carrying out various development
programmes and it will raise the deficit in their balance of payments.
– These developmental imports cause BOP disequilibrium.
 Cyclical Fluctuations
– Cyclical fluctuations in the business activity bring depression, stagnant
and boom stage in world trade.
– Whenever there is a depression/recession in foreign countries, our
exports will fall due to low demand and there will be reduction in foreign
exchange earnings. This will cause BOP disequilibrium.
– Similarly, the boom condition in foreign countries will increase our
exports and our capacity to earn foreign exchange will increase.
 Causes (types) of the BOP disequilibrium

 Sustained/Secular Disequilibrium
– The sustained or secular disequilibrium refers to a situation when, the BOP
disequilibrium persists for long periods due to certain secular trends in the
economy.
– It is seen in the developed countries where, the disposable income is
generally very high and so the aggregate demand is also very high.
– But due to higher aggregate demands, the production costs are also very
high.
– This would result in higher prices, which may result in the imports being
much higher than exports.
 Structural Disequilibrium
– Structural Disequilibrium occurs due to changes in some sectors of the
economy at home country or foreign country which may alter the demand-
supply relations of exports or imports or both.
– The changes may include development of alternative source of supply,
development of better substitutes, exhaustion of productive resources or
change in transport routes and costs etc.
Causes (types) of the BOP disequilibrium

 Population growth
– The high population growth of a country may lead to increased
imports due to increased demand.
– This will naturally cause the BOP disequilibrium.
 Natural factors
– Natural calamities in the form of floods, no rains may affect the
agricultural and industrial production of a country.
– Then the country will go for increased imports and reduced
exports.
– This will cause discrepancy in the equilibrium of the BOP.
 Political Factors
– A country with political instability may experience large capital
outflow and inadequacy of domestic investment and production.
 Correction of the BOP disequilibrium

 There is not much bothering if there is a surplus in the balance of

payments, however, every country strives to remove or at least reduce a
balance of payments deficit.
 There are a number of adjustments, which are done to correct the balance
of payments disequilibrium.
 There are two categories of measures to correct the BOP disequilibrium:
– Automatic Measures
– Deliberate Measures
Correction of the BOP disequilibrium

 Automatic Measures
 If the market forces of demand and supply are allowed to
have free play, in course of time, equilibrium will be
automatically restored.
 This can be understood by a simple example.
– Whenever there is a deficit, demand for foreign exchange
exceeds its supply and this result in an increase in the
exchange rate and a fall in the external value of the
domestic currency.
– This would result in the exports of the country go cheaper
and imports dearer than before.
– Consequently, the increase in exports and fall in imports
restore the balance of payments equilibrium.
Correction of the BOP disequilibrium

 Deliberate measures
 Deliberate Measures refer to the correction of disequilibrium
by means of measures taken deliberately with this end in
view.
 There are various deliberate measures such as
– Monetary measures such as Monetary Contraction,
Devaluation, Exchange Control
– Trade measures : Export Promotion, Import Control
– Miscellaneous measures
 Correction of the BOP disequilibrium

 Monetary Contraction
 The contraction or expansion of money supply affect the level of aggregate
domestic demand, domestic price level and the demand for imports and exports,
and this intervention can be used to correct the disequilibrium of the BOP.
– We assume there is a situation of balance of payments deficit.
– The BOP deficit means that there is an increased level of aggregate demand
that have led to the increased imports.
– When the money supply is contracted, it would leave less money in the
system and finally would reduce the purchasing power.
– The reduced purchasing power would reduce the aggregate demand.
– The reduced aggregate demand also reduce the domestic prices.
– The reduced domestic prices also reduce the demand for the imports.
– The fall in the domestic prices would encourage more exports.
– Thus, the overall result in case of monetary contraction is that Imports
decrease and Exports Increase.
– This results in the correction of a BOP deficit situation.
 Correction of the BOP disequilibrium
 Devaluation
 Devaluation is defined as a reduction of the official rate at which the currency is exchanged for
another currency.
 The idea behind currency devaluation is to stimulate its exports and discourage imports to correct the
disequilibrium.
 The direct impact of devaluation is that it makes the export goods cheaper and imports dearer. How?
Let‘s understand:
– We assume that Current Rate of Dollar is Rs. 55.
– In this situation, an exporter in India would realize Rs. 5500 for an export worth 100 Dollars.
– We assume that the Rupee is devalued and now a Dollar becomes of Rs. 65
– In this situation, the same exporter would realize Rs. 6500.
– The result is that Export earnings would increase and export of good would become cheaper.
– We again assume that there is an importer (in India) who needs to make a payment of $ 100 to
a party sitting abroad.
– At Rs. 55, this importer would need Rs. 5500 to make payment.
– At Rs. 65, this importer would need Rs. 6500 to make payment.
– The result is the import becomes dearer.
– So, most commonly, the Currency devaluation is used as a tool to correct the BOP deficit.
Correction of the BOP disequilibrium

 Exchange Control
– This is yet another popular measure of correcting the BOP deficit.
– Under the exchange control, the government via the RBI assumes complete control
over the foreign exchange reserves and earnings of the country.
– The recipients of foreign exchange, like exporters, are required to surrender foreign
exchange to the government/central bank in exchange for domestic currency.
– By virtue of its control over the use of foreign exchange, the government can
control imports and also increase its foreign currency reserves.
 Export Promotion
– This may include the reduction and abolition of the export duties, providing export
subsidy, encouraging export production and export marketing by giving monetary,
fiscal, physical and institutional incentives and facilities.
 Import Control:
– This may be done by improving or enhancing import duties, restricting imports
through import quotas, licensing and even prohibiting altogether the import of
certain inessential items.
 Miscellaneous Measures
– Other measures are promotion of tourism to attract foreigners and providing
incentives to enhance inward remittances.
Approaches of Balance of Payments

 Following are the top 3 approaches to

balance of payments
– 1. The Elasticity Approach
– 2. The Absorption Approach
– 3. The Monetary Approach
The Elasticity Approach
 Marshall-Lerner Condition:
– The elasticity approach to BOP is associated with the Marshall-Lerner
condition which was worked out independently by these two
economists.
– It studies the conditions under which exchange rate changes restore
equilibrium in BOP by devaluing a country‘s currency.
– This approach is related to the price effect of devaluation.
– When a country devalues its currency, the domestic prices of its
imports are raised and the foreign prices of its exports are reduced.
– Thus devaluation helps to improve BOP deficit of a country by
increasing its exports and reducing its imports.
– But the extent to which it will succeed depends on the country‘s
price elasticities of domestic demand for imports and foreign
demand for exports.
 The Elasticity Approach
 The Marshall-Lerner condition states that ―when the sum of price
elasticities of demand for exports and imports in absolute terms is
greater than unity, devaluation will improve the country‘s balance of
payments‖, i.e.
ex + em > 1
– where ex is the demand elasticity of exports and em is the demand
elasticity for imports.
– On the contrary, if the sum of price elasticities of demand for exports
and imports, in absolute terms, is less than unity, ex + em< 1,
devaluation will worsen (increase the deficit) the BOP.
– If the sum of these elasticities in absolute terms is equal to unity,
ex + em = 1, devaluation has no effect on the BOP situation which
will remain unchanged.
 The Elasticity Approach
 The following is the process through which the Marshall-Lerner condition operates in removing BOP
deficit of a devaluing country.
– Devaluation reduces the domestic prices of exports in terms of the foreign currency. With low
prices, exports increase.
– The extent to which they increase depends on the demand elasticity for exports.
– It also depends on the nature of goods exported and the market conditions.
– If the country is the sole supplier and exports raw materials or perishable goods, the demand
elasticity for its exports will be low.
– If it exports machinery, tools and industrial products in competition with other countries, the
elasticity of demand for its products will be high, and devaluation will be successful in correcting a
deficit.
– Devaluation also increases the domestic price of imports which will reduce the import of goods.
– By how much the volume of imports will decline depends on the demand elasticity of imports.
– The demand elasticity of imports depends on the nature of goods imported by the devaluing
country.
– It is only when the import elasticity of demand for products is high that devaluation will help in
correcting a deficit in the balance of payments.
 Thus it is only when the sum of the elasticity of demand for exports and the elasticity of demand for
imports is greater than one that devaluation will improve the balance of payments of a country
devaluing its currency.
 The Elasticity Approach
 The J-Curve Effect:
 Empirical evidence shows that the Marshall- Lerner condition is satisfied
in the majority of advanced countries.
 But there is a general consensus among economists that both demand-
supply elasticities will be greater in the long run than in the short run.
 The effects of devaluation on domestic prices and demand for exports
and imports will take time for consumers and producers to adjust
themselves to the new situation.
 The short-run price elasticities of demand for exports and imports are
lower and they do not satisfy the Marshall-Lerner condition.
 Therefore, to begin with, devaluation makes the BOP worse in the short-
run and then improves it in the long-run.
 This traces a J-shaped curve through time. This is known as the J-curve
effect of devaluation.
 This is illustrated in adjacent figure where time is taken on the horizontal
axis and deficit-0-surplus on the vertical axis.
 Suppose devaluation takes place at time T.
 In the beginning, the curve / has a big loop which shows increase in BOP deficit beyond D.
 It is only after time T1 that it starts sloping upwards and the deficit begins to reduce.
 At time T2 there is equilibrium in BOP and then the surplus arises from T2 to J.
 If the Marshall-Lerner condition is not satisfied, in the long run the J-curve will flatten out to F from T2.
 The Absorption Approach
 The absorption approach to balance of payments is based on the Keynesian national income
relationships. It is, therefore, also known as the Keynesian approach.
 It runs through the income effect of devaluation as against the price effect to the elasticity
approach.
 The theory states that if a country has a deficit in its balance of payments, it means that
people are ‗absorbing‘ more than they produce.
– Domestic expenditure on consumption and investment is greater than national income.
 If they have a surplus in the balance of payments, they are absorbing less.
– Expenditure on consumption and investment is less than national income.
 Here the BOP is defined as the difference between national income and domestic expenditure.
 This approach was developed by Sydney Alexander.
 The analysis can be explained in the following form Y = C + Id + G + X-M … (1)
– where Y is national income, C is consumption expenditure, Id is total domestic
investment, G is autonomous government expenditure, X represents exports and M
imports.
 The sum of (C + Id + G) is the total absorption designated as A, and the balance of payments
(X – M) is designated as B.
 Thus Equation (1) becomes
– Y=A+B
– or B = Y-A …(2)
– which means that BOP on current account is the difference between national income (Y)
and total absorption (A).
 The Absorption Approach
 BOP can be improved by either increasing domestic income or reducing the absorption.
 For this purpose, Alexander advocates devaluation because it acts both ways.
– First, devaluation increases exports and reduces imports, thereby increasing the national
income.
 The additional income so generated will further increase income via the multiplier effect.
 This will lead to an increase in domestic consumption.
 Thus the net effect of the increase in national income on the balance of payments is the
difference between the total increase in income and the induced increase in absorption, i.e.,
– DB = DY-DA … (3)
 Total absorption (DA) depends on the marginal propensity to absorb (a) when there is
devaluation. Devaluation also directly affects absorption which we write as D. Thus
– DA = a DY + DD … (4)
 Substituting equation (4) in (3), we get
– DB = DY-aDY-DD
– or DB = (1 – a) DY-DD …(5)
 The equation points toward three factors which explain the effects of devaluation on BOP.
They are: (i) the marginal propensity to absorb (a), (ii) change in income (DY), and (iii)
change in direct absorption (DD).
 It may be noted that since a is the marginal propensity (MP) to absorb, (1 – a) is the
propensity to hoard or save. These factors, in turn, are influenced by the existence of
unemployed or idle resources and fully employed resources in the devaluing country.
 The Absorption Approach
 If MP to absorb is less than unity (a< 1), with idle resources in the
country, devaluation will increase exports and reduce imports.
 Output and income will rise and BOP on current account will improve.
 If, on the other hand, a > 1, there will be an adverse effect of
devaluation on BOP.
 However, if they are spending more than the country is producing, then
devaluation will not increase exports and reduce imports, and BOP
situation will worsen.
 Under conditions of full employment if a > 1, the government will have
to follow expenditure reducing policy measures along with devaluation
whereby the resources of the economy are so reallocated as to increase
exports and reduce imports. Ultimately, BOP situation will improve.
The Monetary Approach
 The monetary approach to the balance of payments is an
explanation of the overall balance of payments.
 It explains changes in balance of payments in terms of the demand
for and supply of money.
 According to this approach, ―a balance of payments deficit is always
and everywhere a monetary phenomenon.‖
 Therefore, it can only be corrected by monetary measures.

The Monetary Approach
Given certain assumptions (e.g. Law of one price i.e. identical goods sold in different
countries at the same price; all countries working under full employment etc.), the
monetary approach can be expressed in the form of the following relationship
between the demand for and supply of money: The demand for money (MD) is a
stable function of income (Y), prices (P) and rate of interest (i)
– Md=f(Y, P ,i) ……………(1)
 The money supply (Ms) consists of domestic money (credit) (D) and country‘s foreign
exchange reserves (R).
– Ms = D + R ………...(2)
 Since in equilibrium the demand for money equals the money supply,
– Md = Ms ……………….(3)
– or Md = D + R ………….(4)
 A balance of payments deficit or surplus is represented by changes in the country‘s
foreign exchange reserves. Thus
– DR = DMd -DD ……………. (5)
– or DR = B ……………..…(6)
– where B represents balance of payments which is equal to the difference between
change in the demand for money (DMd) and change in domestic credit (DD).
 A balance of payments deficit means a negative B which reduces R and the money
supply.
 On the other hand, a surplus means a positive B which increases R and the money
supply.
 When B = 0, it means BOP equilibrium or no disequilibrium of BOP.

The Monetary Approach
The automatic adjustment mechanism in the monetary approaches is explained under both the fixed
and flexible exchange rate systems.
 Under the fixed exchange rate system,
– assume that MD = Ms so that BOP (or B) is zero.
– Now suppose the monetary authority increases domestic money supply, with no change in the
demand for money.
– As a result, Ms > MD and there is a BOP deficit.
– People who have larger cash balances increase their purchases to buy more foreign goods and
securities.
– This tends to raise their prices and increase imports of goods and foreign assets.
– This leads to increase in expenditure on both current and capital accounts in BOP, thereby
creating a BOP deficit.
– To maintain a fixed exchange rate, the monetary authority will have to sell foreign exchange
reserves and buy domestic currency.
– Thus the outflow of foreign exchange reserves means a fall in R and in domestic money supply.
– This process will continue until Ms = MD and there will again be BOP equilibrium.
– On the other hand, if Ms < MD at the given exchange rate, there will be a BOP surplus.
– Consequently, people acquire the domestic currency by selling goods and securities to foreigners.
– They will also seek to acquire additional money balances by restricting their expenditure relatively
to their income.
– The monetary authority on its part, will buy excess foreign currency in exchange for domestic
currency.
– There will be inflow of foreign exchange reserves and increase in domestic money supply.
– This process will continue until Ms = MD and BOP equilibrium will again be restored.
– Thus a BOP deficit or surplus is a temporary phenomenon and is self-correcting (or automatic) in
the long-run.
 The Monetary Approach
– This is explained in Figure below –
– In Panel (A) of the figure, MD is the stable money demand curve and Ms is the money supply curve.
The horizontal line m (D) represents the monetary base which is a multiple of domestic credit, D
which is also constant. This is the domestic component of money supply that is why the Ms curve
starts from point C.
– Ms and MD curves intersect at point E where the country‘s balance of payments is in equilibrium and
its foreign exchange reserves are OR.
– In Panel (B) of the figure, PDC is the payments disequilibrium curve which is drawn as the vertical
difference between Ms and MD curves of Panel (A). As such, point B0 in Panel (B) corresponds to point
E in Panel (A) where there is no disequilibrium of balance of payments.
– If Ms < MD there is BOP surplus of SP
in Panel (A). It leads to the inflow of
foreign exchange reserves which rise
from OR1 to OR and increase the
money supply so as to bring BOP
equilibrium at point E.
– On the other hand, if Ms > MD there is
deficit in BOP equal to DF. There is
outflow of foreign exchange reserves
which decline from OR2 to OR and
reduce the money supply so as to
reestablish BOP equilibrium at point E.
– The same process is illustrated in Panel
(B) of the figure where BOP
disequilibrium is self-correcting or
automatic when B1S1 surplus and B2D1
deficit are equal to SP and DF
respectively.
 The Monetary Approach
 Under a system of flexible (or floating) exchange rates, when B = O, there is
no change in foreign exchange reserves (R).
 But when there is a BOP deficit or surplus, changes in the demand for money
and exchange rate play a major role in the adjustment process without any
inflow or outflow of foreign exchange reserves.
 Suppose the monetary authority increases the money supply (Ms > MD) and
there is a BOP deficit. People having additional cash balances to buy more
goods thereby raising prices of domestic and imported goods.
 There is depreciation of the domestic currency and a rise in the exchange rate.
 The rise in prices, in turn, increases the demand for money thereby bringing
the equality of MD and Ms without any outflow of foreign exchange reserves.
 The opposite will happen when MD > Ms, there is fall in prices and appreciation
of the domestic currency which automatically eliminates the excess demand for
money.
 The exchange rate falls until MD = Ms and BOP is in equilibrium without any
inflow of foreign exchange reserves.
Thank you