Balance of Payments

An open economy is an economy which has

transactions with the rest of the world.
Globalization has raised awareness among
millions of people of the forces unleashed
when an economy is opened up to trade and
world capital markets. No survey of
macroeconomic theory would be complete
without some coverage of open economy
o An Open Economy
Almost all the economies maintain trade relations with each other.
To take advantage of low cost, better quality of products produced
abroad are imported by the countries (M). On the other hand , part
of the commodities produced in the domestic markets are exported
(X) to other countries. Whenever a country imports commodities
there is an outflow of income from the domestic country to a
foreign country. Thus, imports constitute a leakage from the
circular flow of income. On the other hand, when a foreign country
buys commodities from the domestic country, there is an inflow of
income into the domestic market. Thus, exports cause an injection
of income into the economy
S, T, and M cause leakages and I, G, and X constitute injections in
an open economy with government. Economy is in equilibrium
when total leakages are equal to total injections, which implies
following identity
S+T+M=I+G+X
If the inflow exceed leakages, the circular flow
grows. This state of disequilibrium shows the
economic growth and the phase of prosperity.
The phase of prosperity continues until the
economy is again brought to the equilibrium state
where injections are equal to leakages. On the
other hand, injections are less than leakages the
circular flow shrinks reflecting the deceleration in
economic activities and the phase of recession in
economic activities. In an open economy, a
countrys spending need not equal its
production in every period
 The extent of the openness varies greatly
across nations. The000 degree of openness is
partly due to the economic policies followed
by the respective governments and partly due
to their absolute/comparative
advantages/disadvantages. Openness causes
interdependence, which produces mixed
blessings. On the positive side, households
can consume what is not produced in the
country and firms can invest more than the
domestic saving, besides the advantage of
better prices and qualities
o Balance of Payments Accounting
The balance of payments account, which are
a part of the national income accounts are the
record of a countrys international
transactions. Any transaction which involves a
flow of funds into the country is a credit item
and is entered with a plus sign; any
transactions that involves a flow of funds out
of the country is a debit item and is entered
with a minus sign. The components of the
balance of payments accounts are:
 The Current Account (CA)
The current account measures a countrys trade in currently produced
goods and services, along with unilateral transfers between countries. Its
three separate components are:
Net Export of Goods and Services
Net Exports often are broken into two categories, goods and services.
Internationally traded services include transportation, tourism, insurance,
education, and financial services, among others
Net Income from Abroad
Net income from abroad equals income receipts from abroad minus
income payments to residents of other countries. The income receipts
flowing into a country, which are credit items in the current account,
consist of compensation received from residents working abroad plus
investment income from assets abroad ( interest payments, dividends,
royalties, and other returns that residents of a country receive from assets
(bonds, stocks, and patents) that they own in other countries. The income
payments flowing out of a country consist of compensation paid to foreign
resident working in the country plus payments to foreign owners of assets
in the country
 Net Unilateral Transfers
Unilateral transfers are payments from one country
to another that do not correspond to the purchase of
any good, service, or asset. For example an official
foreign aid or a gift of money from a resident of one
country to family members living in another country.
Adding all the credit items and subtracting all the
debit items in the current account yields a number
called the current account balance. The current
account may be positive , negative, or balanced
 The Capital and Financial Account (KFA)
International transactions involving assets,
either real or financial, are recorded in the capital
and financial account, which consists of a capital
account and a financial account. The capital
account encompasses unilateral transfers of
assets between countries, such as debt
forgiveness or migrants transfers (the assets that
migrants take with them when they move into or
out of a country). The capital account balance
measures the net flow of assets unilaterally
transferred into the country
 The financial account records most of the
transactions involving the flow of assets into or
out of the country. When the home country sells
an asset to another country, the transaction is
recorded as a financial inflow and as a credit
item in the financial account of the home
country. When the home country buys an asset, it
appears as a debit item in the home countrys
financial account
The financial account balance equals the value
of financial inflows minus the value of financial
outflows. The capital and financial account
balance is the sum of capital account balance and
the financial account balance
 Another set of financial account transactions is the
transactions in official reserve assets. Official reserve assets
are assets, other than domestic money or securities that can
be used in making international payments. The official
reserves of central banks now include gold, government
securities of major industrialized economies, foreign bank
deposits and special assets created by the IMF
The official settlements balance also called the balance of
payments as the net increase in a countrys official reserve
assets. A country that increases its net holdings of reserve
assets during a year has a balance of payments surplus, and
a country that reduces its net holdings of reserve assets has
a balance of payments deficit