Introduction BoP Definition BoP Principle BoP: Components BOP Disequilibria Approaches to BOP Summary& Conclusio

Balance of Payments

Etsubdink Sileshi(PhD)

May 6, 2023

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Introduction BoP Definition BoP Principle BoP: Components BOP Disequilibria Approaches to BOP Summary& Conclusio

Content

Introduction

BoP Definition

BoP Principle

BoP: Components

BOP Disequilibria

Approaches to BOP

Summary& Conclusion

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Introduction

▶ One important economic indicator for policy-makers in an

open economy is the balance of payments.
▶ Deficits may lead to the government raising interest rates or
reducing public expenditure to reduce expenditure on imports.
▶ Alternatively, deficits may lead to calls for protection against
foreign imports or capital controls to defend the exchange
rate.

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Balance of Payments(BoP): Definition

▶ The balance of payments is a summary statement in which, in

principle, all the transactions of the residents of a nation with the
residents of all other nations are recorded during a particular period
of time, usually a calendar year.
▶ The term residents comprises individuals, households, firms and the
public authorities, and there are some problems that arise with
respect to the definition of a resident such as MNCs and their
subsidiaries.
▶ It reveals how many goods and services the country has been
exporting and importing, and whether the country has been
borrowing from or lending money to the rest of the world.
▶ The authorities collect their information from the customs
authorities, surveys of tourist numbers and expenditures, and data
on capital inflows and outflows is obtained from banks, pension
funds, multinationals and investment houses.
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BOP Accounting Principle

▶ A nation’s international transactions is recorded using, the

accounting procedure known as double-entry bookkeeping -
a transaction is entered twice.
▶ Each transaction between a domestic and foreign resident has
two sides to it, a receipt and a payment, and both these sides
are recorded in the balance-of-payments statistics.
▶ Each receipt of currency from residents of the rest of the world
is recorded as a credit item (a plus in the accounts) while,
▶ Each payment to residents of the rest of the world is recorded
as a debit item (a minus in the accounts).
▶ Traditionally, the statistics are divided into two main sections
- the current account and the capital account, with each part
being further sub-divided.
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The Components of BBP: The Trade Balance

▶ The trade balance is sometimes referred to as the visible

balance which represents the difference between receipts for
exports of goods and expenditure on imports of goods which
can be visibly seen crossing frontiers.
▶ The receipts for exports are recorded as a credit in the balance
of payments, while the payment for imports is recorded as a
debit.
▶ When the trade balance is in surplus this means that a
country has earned more from its exports of goods than it has
paid for its imports of goods.

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The Components of BOP: The Current Account Balance

▶ The current account balance is the sum of visible trade balance

and the invisible balance.
▶ The receipts for exports are recorded as a credit in the balance of
payments, while the payment for imports is recorded as a debit.
▶ When the trade balance is in surplus this means that a country has
earned more from its exports of goods than it has paid for its
imports of goods.
▶ The invisible balance shows the difference between revenue
received for exports of services and payments made for imports of
services such as shipping, tourism, insurance and banking.
▶ In addition, receipts and payments of interest, dividends and profits
are recorded in the invisible balance because they represent the
rewards for investment in overseas companies, bonds and equity;
while payments reflect the rewards to foreign residents for their
investment in the domestic economy.
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Introduction BoP Definition BoP Principle BoP: Components BOP Disequilibria Approaches to BOP Summary& Conclusio

The Components of BOP: The Current Account Balance

▶ Unilateral transfers are also included in the invisible balance;

these are payments or receipts for which there is no
corresponding quid pro quo. Examples of such transactions
are migrant workers’ remittances to their families back home,
the payment of pensions to foreign residents, and foreign aid.
▶ Unilateral payments can be viewed as a fall in domestic
income due to payments to foreigners and so are recorded as a
debit; while unilateral receipts can be viewed as an increase in
income due to receipts from foreigners and consequently are
recorded as a credit.

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The Components of BOP:The Capital Account Balance

▶ The capital account records transactions concerning the movement

of financial capital into and out of the country: borrowing, sales of
overseas assets, and investment in the country by foreigners.
▶ These items are referred to as capital inflows and are recorded as
credit items in the BOP. Capital inflows are, in effect, a decrease in
the country’s holding of foreign assets or increase in liabilities to
foreigners. and they are recorded as they are pluses( as the export
of an IOU).Similarly investment by foreign residents is the export of
equity or bonds, while sales of overseas investments is an export of
those investments to foreigners.
▶ Capital outflows are, in effect, an increase in the country’s holding
of foreign assets or decrease in liabilities to foreigners. These items
are recorded as debits as they represent the purchase of an IOU
from foreigners

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The Components of BOP:Official Settlements Balance

▶ The sum of all the items recorded in the current account,

capital account and the balance of official financing which in
theory should sum to zero. But, there exists a discrepancy.
▶ To ensure that the credits and debits are equal it is necessary
to incorporate a statistical discrepancy for any difference
between the sum of credits and debits.
▶ There are several possible sources of this error.
i. Sampling estimates derived from separate sources,that some
error is unavoidable.
ii. The desire to avoid taxes firms to under-invoice their exports
and over-invoice their imports
iii. The BOP records receipts and payments for a transaction
between domestic and foreign residents, but it can happen that
a good is imported but the payment delayed.
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The Components of BOP:Official Settlements Balance

▶ The summation of the current balance, capital account

balance and the statistical discrepancy gives the official
settlements balance.
▶ The balance on this account is important because it shows the
money available for adding to the country’s official reserves or
paying off the country’s official borrowing.
▶ Such reserves are held primarily to enable the central bank to
purchase its currency should it wish to prevent it depreciating.
▶ Any official settlements deficit has to be covered by the
authorities drawing on the reserves, or borrowing money
from foreign central banks or the IMF (recorded as a plus in
the accounts).

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The Components of BOP

ROW : the rest of the world.

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Recording of Transactions in the Balance of Payments

▶ To understand exactly why the sum of credits and debits in

the balance of payments should sum to zero we consider some
examples of economic transactions between domestic and
foreign residents.
▶ There are basically five types of such transactions that can
take place:
1. An exchange of goods/services in return for a financial asset.
2. An exchange of goods/services in return for other
goods/services. Such trade is known as barter or countertrade.
3. An exchange of a financial item in return for a financial item.
4. A transfer of goods or services with no corresponding quid pro
quo (for example military and food aid).
5. A transfer of financial assets with no corresponding quid pro
quo (for example, migrant workers’ remittances to their
families abroad, a money gift).
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The Components of Balance of Payments: BoP

Components

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Balance-of-Payments Surplus or Deficit

▶ The BOP always balances since each credit in the account has
a corresponding debit elsewhere.
▶ However, this does not mean that each of the individual
accounts that make up the BOP is necessarily in balance; for
instance, the current account can be in surplus while the
capital account is in deficit.
▶ When talking about a BOP deficit or surplus we are saying
that a subset of items in the BOP are in surplus or deficit.
▶ BOP is a double entry accounting record. Hence, under
normal circumstances, the receipts and payments(credit vs
debit) must be in balance.
▶ Thus, there arises BOP surplus or deficit. This imbalance is
what is known as BOP disequilibrium.
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Balance-of-Payments Surplus or Deficit

▶ A nation’s BOP is in disequilibrium when autonomous

receipts(credits) are different from autonomous
payments(debits).
▶ A surplus in the balance of payments is defined as a excess of
autonomous receipts over autonomous payments. While a
deficit is an excess of autonomous payments over autonomous
receipts.
▶ Autonomous receipts > autonomous payments =surplus
(Credit>Debit= favourable BOP)
▶ Autonomous receipts > autonomous payments = deficit
(Credit<Debit= Unfavourable BOP)
▶ Causes of disequilibrium include : structural change in the
economy, changes in exchange rate, business cycles, general
price levels.
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Financing BOP

▶ Persistent BOP deficits can be financed using

▶ Forex reserves
▶ Gold reserves
▶ Loans
▶ However, the above measures are short term. In the long run,
BOP deficits can be reduced/eliminated by:
▶ Export promotion
▶ Import substitution
▶ Reducing inflation
▶ Exchange rate management

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Exchange Rate and BOP

▶ Depreciation of a currency encourages exports and reduces imports

thereby leading to a favorable BOP.
▶ The official settlements concept of a surplus or deficit is not as
relevant to countries that have floating exchange rates as it is to
those with fixed exchange rates.
▶ If exchange rates are left to float freely the official settlements
balance will tend to zero as central banks do not buy or sell.
▶ If the sales of a currency exceed the purchases then the
currency will depreciate, and
▶ If sales are less than purchases the currency appreciates.
▶ Under a fixed exchange-rate system a country that is running an
official settlements deficit will find that sales of its currency exceed
purchases. To avert a devaluation of the currency authorities have
to sell reserves of foreign currency to purchase the home currency.
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Elasticity Approach to BOP

▶ The BOP problems are due to the disequilibrium in the physical

trade flows, namely exports and imports of goods and services.
Thus it could be analyzed on the basis of partial elasticities of the
exports and imports and the role of exchange rate in the adjustment
of BOP to a devaluation.
▶ BOP adjustment through exchange rate changes relies upon the
effect of the relative prices of domestic and foreign goods on the
trade flows with the rest of the world.
▶ This relative price, or terms of trade, is defined by the ratio of
export and import prices in domestic currency.The terms of trade
represents the amount of imports that can be obtained in exchange
for a unit of exports
▶ A depreciation in the exchange rate at unchanged domestic and
foreign prices in the respective currencies makes domestic goods
cheaper in foreign markets and foreign goods more expensive in the
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Elasticity Approach to BOP

▶ According to the elasticity approach there are two direct effects of

exchange rate changes on the balance on goods and services:
▶ The volume effect:e increase in the volume of exports due to the
increase in the price competitiveness of the exports and the decrease
in the volume of imports due to the decrease in the price
competitiveness of imports due to the devaluation.
▶ The price effect: Due to the devaluation exports become cheaper
measured in foreign currency and imports become more expensive
measured in home currency.
▶ The volume effect clearly contributes to improving the goods and
services account while the price effect clearly contributes to the
worsening of the goods and services account.
▶ Quantity - adjustment period is defined as a period in which both
quantities and prices can change. If the suitable conditions on the
elasticities are fulfilled, the balance of payments ought to improve
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Elasticity Approach to BOP

▶ The current account balance (CA) when expressed in terms of the

domestic currency is given by”

CA = PXv − SP∗ Mv

▶ Where P is the domestic price level, Xv is the volume of domestic

exports, S is the exchange rate (domestic currency units per unit of
foreign currency), P∗ is the foreign price level and Mv is the volume
of imports.
▶ By setting domestic and foreign price levels at unity, we can simplify
the above expression as

CA = Xv − SMv

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Elasticity Approach to BOP

▶ And if we take the difference

dCA dX dM dS
dCA = dX − SdM − MdS ⇒ = −S −M
dS dS dS dS
▶ And we know the price elasticity of demand for exports ηx is given
by:
dX/X dS
ηx = ⇒ dX = ηx X
dS/S S
▶ Similarly,the price elasticity of demand for imports is ηm is given by:
dM/M dS
ηm = − ⇒ dM = −ηm M
dS/S S
▶ Then we can further simplify the difference expression as
dCA ηx X dCA 1 ηx X
= +ηm M−M ⇒ = +ηm −1Multiply both sides by M
dS S dS M SM
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Elasticity Approach to BOP

▶ If we initially have a balanced trade, then we have

dCA
= M(ηx + ηm − 1)Marshall-Lerner condition
dS

▶ The Marshall-Lerner condition and says that starting from a

position of equilibrium in the current account, a devaluation will
improve the current account; that is, dCA/dS > 0. Holds in
industrialized countries
▶ If the sum of these two elasticities is less than unity then a
devaluation will lead to a deterioration of the current account.
Applies for developing countries.

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Elasticity Approach to BOP: Example

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Elasticity Approach to BOP

▶ From the above table, we have:-

▶ The price effect - exports become cheaper measured in
foreign currency - a UK export earns only $1.50
post-devaluation compared to $2 prior to devaluation. Imports
become more expensive measured in the home currency, each
unit of imports cost £2.50 prior to the devaluation but costs
£3.33 post-devaluation. The price effect clearly contributes to
a worsening of the UK current account.
2. The volume effect - the fact that exports become cheaper
should encourage an increased volume of exports, and the fact
that imports become more expensive should lead to a
decreased volume of imports. The volume effect clearly
contributes to improving the current account.

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Elasticity Approach to BOP

▶ Evidence shows that a devaluation may work better for

industrialized countries than for developing countries. Many
developing countries are heavily dependent upon imports so that
their price elasticity of demand for imports is likely to be very low.
▶ Even for the developed countries, the effect of devaluation on
current account after a certain period. This can be shown using the
J-curve.
▶ There are numerous reasons which explain the slow responsiveness
of export and import volumes in the short run and why the response
is far greater in the longer run; three of the most important are:
time lag in consumer responses, time lag in producer
responses - and imperfect competition such as foreign exporters
reducing prices which may offset the cost of imports triggered by
devaluation

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Elasticity Approach to BOP: J-curve

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Absorption Approach to BOP

▶ The BOP problems arise due to the disequilibrium between

domestic income and expenditures and has to be analyzed in a
broader context than the elasticity approach.
▶ The absorption approach focuses on the fact that current
account(CA) imbalances can be viewed as the difference
between domestic output(Y) and domestic spending
(absorption/A)
CA = X − M = Y − A
▶ Understanding how devaluation affects both income and
absorption is therefore central to the absorption approach to
the balance of payments.
▶ If devaluation raises domestic income relative to domestic
spending the current account will improve.
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Absorption Approach to BOP

▶ There are two important effects of devaluation on income that

need to be examined:
▶ The employment effect : If the economy is below the full
employment level, then there will be an increase in net exports
following a devaluation. It is not clear whether the
employment effect will raise or lower national income.
▶ Terms of trade effect: A devaluation tends to make imports
more expensive in domestic currency terms, which is not
matched by a corresponding rise in export prices. This means
that the terms of trade deteriorates.
▶ A deterioration in the terms of trade represents a loss of real
national income because more units of exports have to be
given to obtain one unit of imports.

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Monetary Approach to BOP

▶ The approach emphasizes the importance of monetary factors

in the adjustment of BOP to different disturbances in the
money market.
▶ The main focus of the monetary approach is that
disequilibrium in the BOP reflects disequilibrium in the money
market, excess demand or supply of money.
▶ According to this view, any monetary disequilibrium produces
an effect on the aggregate expenditure for goods and services
(absorption) in the sense that:
▶ An excess supply of money causes absorption to be greater
than income and a BOP deficit. The only way of absorbing
more than one produces is to receive from foreign countries
more than one supplies to them.
▶ An excess demand for money causes absorption to be smaller
than income and a BOP surplus.
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▶ The Balance of Payments is a set of accounts that

summarizes all transactions performed by the country in a
particular period with the RWO.
▶ The BOP components include current account, capital
account ,and errors and Omissions.
▶ When autonomous recepits < payments, there occurs
disequilibrium- which may be bad.
▶ The absorption approach, like the elasticity approach, does
not provide a clear answer to the question of whether a
devaluation leads to an improvement in the current account.
▶ In both cases, the effect depends on how economic agents
respond to the change in relative prices that is implied by a
devaluation.
▶ Demand elasticities are higher in the long run than in the
short run, leading to a possible J-curve effect, and the effects
of a devaluation on income and absorption will be spread over
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