Balance of Payments

What is BOP?

A nations BOP is a summary statement of all its economic transactions with the rest of the world during a given year. Each transaction is entered in the BOP as a credit or a debit. A credit transaction is one that leads to the receipt of a payment from foreigners while a debit transaction leads to a payment to foreigners. The main components of BOP are Current account Capital account Official reserve account
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Current account

This includes trade in goods and services and unilateral transfers The main categories of service transactions are travel and transportation, receipts and payments on foreign investments and military transactions. Unilateral transfers refer to gifts made by individuals and the government to foreigners & gifts received from foreigners The exports of goods & services & receipt of unilateral transfers are entered in the current account as credits (+) because they lead to receipt of payments from foreigners. On the other hand, import of goods & services & granting of unilateral transfers are entered as debits (-) because they lead to payments to foreigners
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Capital account

This shows the change in the nations assets abroad & foreign assets in the nation. It includes direct investments (such as the building of a foreign plant), the purchase or sale of foreign securities (stocks, bonds and treasury bills), and the change in the nations non bank and bank claims on and liabilities to foreigners during the year

Increase in nations assets abroad & reduction in foreign assets in the nation (other than official reserve assets) are capital outflows or debits (-) because they lead to payment to foreigners. On the other hand, decrease in nations assets abroad & increase in foreign assets in the nation (other than official reserve assets) are capital inflows or credits (+) because they lead to receipts from foreigners

Official reserve account

Measures the change in a nations official reserve assets & the change in foreign official assets in the nation during the year Official reserve assets include the gold holdings of the nations monetary authorities, special drawing rights (SDRs), the nations reserve position in the IMF and the official foreign currency holdings of the nation An increase in the nations official reserve assets are debits (-) while an increase in foreign official assets in the nation are credits(+)

Double Entry Bookkeeping

Each international economic transaction is entered either as a credit or as a debit in the nations balance of payments. But every time a credit or a debit transaction is entered, an offsetting debit or credit respectively of the same amount is also recorded in one of the three accounts. This double entry book keeping The reason for this is that every transaction has two sides- we sell something and we receive payment for it & we buy something and we must pay for it.
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Statistical Discrepancy

Theoretically double entry book- keeping should result in total credits being equal to total debits when all three accounts of the BOP are taken together. However, because of recording errors and omissions, this equality does not usually hold. Thus a special entry called statistical discrepancy is necessary to balance the nations BOP statement.
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Disequilibrium in the BOP

In the accounting sense BOP always balances. But this trivial balance in the BOP of a country does not mean that the BOP is always in equilibrium. There can be disequilibrium i.e. a deficit or a surplus in the BOP of a country though the BOP always balances in the accounting or ex-post sense

Understanding the disequilibrium in the BOP

To understand this we divide all the transactions recorded in the accounting balance into two major categoriesAutonomous transactions Accommodating transactions

Autonomous transactions

These are those transactions which are undertaken for their own sake, normally in response to business considerations and incentives and sometimes in response to political considerations as well. These transactions take place independently of the balance of payments position of the reporting country. Examples: these include virtually all exports & imports of goods & services, unilateral transfers, direct investment or portfolio investment motivated by a desire to earn either a higher return or to find a safe refuge

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Accommodating transactions

These are those transactions that do not take place for their own sake, but because autonomous transactions are such as to leave a gap to be filled. These are those transactions that occur as a direct consequence of the BOP situations. Example: include the sale of gold or foreign currencies by central bank with a view to filling the gap between the receipts & payments of foreign exchange by the residents country and a loan received by the monetary authorities of the reporting country from foreign government with the purpose of filling the gap between the autonomous receipts and autonomous payments.
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Understanding the disequilibrium in the BOP contd..

When autonomous receipts and autonomous payments are equal accommodating transactions do not take place Thus whether there is equilibrium or disequilibrium in the BOP of the country we consider the autonomous transactions If autonomous receipts = autonomous payments, the BOP is in equilibrium; if total autonomous receipt > total autonomous payments, the BOP has a surplus; if total autonomous receipt < total autonomous payments, the BOP has a deficit
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Understanding the disequilibrium in the BOP contd..

By disequilibrium in the BOP of a country we mean imbalance between the autonomous international payments (demand for foreign exchange) and receipts (supply of foreign exchange. A disequilibrium in the BOP of a country appears either as a deficit or as a surplus

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Correcting disequilibrium in the BOP- price-specie flow According to classical theory, if there is a mechanism

deficit in the BOP of a country, then there will be outflow of gold from the country This will result in a fall of money supply and general price level in the country This in turn will increase exports & reduce imports of the deficit country and thus the BOP disequilibrium is automatically corrected
Price-Specie-flow mechanism Gold inflows & outflows changes in the quantities of money changes in the price level
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Correcting disequilibrium in the BOPChanges in foreign foreign exchange changes inin exchange rates can also correct disequilibrium the BOP Foreign rate exchange rate is the price of one unit of foreign currency

expressed in terms of units of home currency A change in foreign exchange rate refers to a change in the value of home currency in terms of the foreign currency Domestic prices in the trading countries remaining unchanged a fall in price of home currency in terms of foreign currency, referred to as depreciation implies that prices of countrys exports will fall in the foreign currency and prices of her imports will rise in home currency Under freely flexible exchange rate system, a deficit in a countrys BOP automatically leads to depreciation ie. results to lowers the price of its home currency in terms of foreign currency. This in turn eliminates the deficit in the BOP.

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Correcting disequilibrium in the BOP A deficit in the BOP of a country lowers the national income-adjustment mechanism

income of the country Import function is given by M =M (Y) where 0< m<1 implying import is an increasing function of national income. So as Y falls M also falls. Similarly, in a country having BOP surplus, Y rises leading to a rise in its M and thereby a rise in the export of deficit country The increase in exports and the fall in imports of the deficit country removes its deficit.
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Deliberate policies to correct BOP disequilibrium

Both price-specie flow as well as income adjustment mechanism are automatic adjustment mechanisms They do not always take place smoothly or even if they take place they take time to operate So the government is often forced to take deliberate policies

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Types of deliberate policies to correct BOP disequilibrium

If the BOP deficit is of a temporary nature the remedies areCountry may borrow foreign exchange from a foreign country or from international monetary institutions like the IMF Country can also attract private capital from abroad by raising the rate of interest in the economy & offering tax concessions to foreign investors Country can also run down its foreign exchange reserves
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Types of deliberate policies to correct BOP disequilibrium

If the BOP disequilibrium is of a long term nature then the country should adopt some measures to increase exports and reduce imports Two important methods are Devaluation or depreciation Deflation Other measures that lead to import control and export promotion can also be adopted.

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Depreciation/Devaluation

This means a fall in the price of the home currency in terms of foreign currency. Now-a-days this term is generally replaced by the term devaluation Devaluation means a reduction in the official value of the home currency in terms of gold. This in turn lowers the price of home currency in terms of foreign currency leading to depreciation. This in turn leads to a fall in price of the countrys exports in foreign currency & as such increases the demand for the countrys exports in the foreign countries. At the same time countrys import prices in terms of home currency increases and lowers the volume of countries imports
Devaluation increases the countrys exports and lowers her imports & hence corrects her BOP position But how much is improved depends on the countrys elasticities of supply of and demand for her exports & imports
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Deflation

This is the policy of reducing the quantity of money in order to reduce the price level and the money income of the people M falls domestic prices fall exports increase & imports fall BOP position is improved Besides, M falls r Foreign capital is attracted BOP position is improved

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Other measures that correct the BOP position

These are the measures that lead to import control and export promotion For example: reduction of export duties, export subsidies, bilateral trade agreement, imposition of import duties, import quotas etc.

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