Balance of Payments ( BoP )

BoP is a statistical statement that systematically summarizes, for a specific time period, the economic transactions of an economy with the rest of the world . IMF BoP Manual Simply stating, BoP refers to a systematic and summary record of a countrys economic and financial transaction with the rest of the world, over a period of time.

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Balance of Payments

Contd.

Balance of Payment components Capital account transactions Current account transactions Official reserves account Unilateral transactions

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Accounting Equilibrium
Since the Balance of Payments is constructed on the basis of double entry book keeping credit is always equal to debit. If debit on current account is greater than the credit, funds flow into the country that are recorded on the credit side of the capital account and the excess debit is wiped out. Thus the concept of Balance of Payment is based on the concept of accounting equilibrium, that is Current account + capital account = 0 The accounting balance is an expost concept. i.e., it describes what has actually happened over a specific period in the past.

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BoP Equilibrium Contd.

In economic sense, BoP of a country is said to be in equilibrium when the demand for foreign exchange is exactly equivalent to the supply of it. Balance of payments is regarded as being in disequilibrium when it shows either a surplus or a deficit. There will be a deficit in BoP when the demand for foreign exchange exceeds its supply, and there will be a surplus when the supply of foreign exchange exceeds the demand.

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BoP Disequilibrium
In the economic sense, a balance of payments equilibrium occurs when a surplus or deficit is eliminated from the balance of payments. But normally, such equilibrium is not found. Rather, it is disequilibrium in balance of payments that is a normal phenomenon. Economic factors Development disequilibrium Cyclical disequilibrium Secular disequilibrium Structural disequilibrium Political factors Sociological factors

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Factors Affecting BoP- briefing

National spending and National output  National income national spending savings invested abroad capital account deficit.  National output national spending export increases current account surplus invested broad capital account deficit. Money supply  Money supply increase domestic price level increase fall in export increase in imports current account deficit.  Money supply decreases exports increases imports dearer current account surplus. o If imports are not controlled, deficit will appear in the trade account.

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Factors Affecting BoP

Interest rate.  Increase in domestic rate turns surplus Exchange rate

Contd.

capital inflow

capital account

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Need For BoP Disequilibrium Adjustment

A country may not be bothers about a surplus in the balance of payments but every country strives to remove or at least reduce the balance of payments deficit. Balance of Trade is largely responsible for the disequilibrium because, it represents a shift in real income. Also adjustments on this account is not very easy. If the Balance of Trade is surplus, its correction is not difficult. But, if the Balance of Trade is deficit and is too large, and if invisible trade surplus is not enough, it will lead to current account deficit. If this current account deficit continues, official reserves will be eroded. If the borrowings of the country increases, it will lead to debt trap. For these reasons, adjustments are necessary for correcting the BoP disequilibrium.

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Different Approaches to Adjustment

Classical Approach Elasticity Approach Keynesian view Absorption Approach New Cambridge School Approach Monetary Approach

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The Classical Approach

The issues of connection between domestic economic variables and the balance of payments responsible for disequilibrium in the latter and its adjustments have been investigated by a number of experts. The classical economists had thought of the balance of payments disequilibrium, but they held the view that it was self adjusting This view based on the price-specie-flow of mechanism, stated that an increase in money based supply raises domestic prices, exports become uncompetitive, export earning drop, foreign goods become cheaper and imports rise. As a result the current account balance goes deficit. Precious metal flows out of the country to support the imports, the quantity of money drops and that lowers the price level.

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The Classical Approach Contd.

Lower the prices in the economy lead to increased exports resulting in the trade balances regaining the equilibrium. This way the classical version of balance of payments adjustment was a refutation of the mercantilist belief that a country could achieve a lasting balance of trade surplus through trade protection and export promotion

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Elasticity Approach
After the collapse of the gold standard, the classical view could not remain tenable The adjustment in the balance of payments disequilibrium was thought of in terms of changes in the fixed exchange rate, that is , by devaluation or upward revaluation but its success dependent upon the elasticity of demand for export and import. Marshal & Lerner explained this phenomenon through the elasticity approach. This elasticity approach is based on the partial equilibrium analysis where everything is held constant except the effects of exchange rate changes on exports and imports.

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Elasticity Approach Contd.

It is also assumed that elasticity of supply of output is infinite so that the price of export in home currency does not rise as demand increases, nor does the price of import fall with a squeeze in demand for import. Again, the approach ignores the monetary effects of variation in exchange rates. Based on these assumptions, devaluation helps improve current account balance only if Em + Ex > 1 Em is the price elasticity of demand for import Ex is the price-elasticity of demand for export

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Elasticity Approach Contd.

If the elasticity of demand is greater than unity, devaluation will lead to contraction f import in the wake of escalated cost of import which is known as pass-through effect and increase in export as a result of lower prices in the international market. The trade deficit will improve. However, the problem is that the trade partner may also devalue its own currency as a retaliatory measure. Moreover, there may be a long lapse of time on account of a time lag either in consumer responses or due to producer responses before the quantities adjust sufficiently to the changes in price. Till then, trade balance would be even worse than that before devaluation.

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Elasticity Approach Contd.

As shown in Figure 1, the trade balance moves deeper into the deficit zone immediately after devaluation but then gradually improves and crosses into the surplus zone. The curve resembles the letter J and so, is known as the J-curve effect

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Elasticity Approach Contd.

The weakness of the elasticity approach is that it is a partial equilibrium analysis. It does not consider the supply and cost changes as a result of devaluation nor does it take into account the income and the expenditure effects of exchange rate changes. The narrow scope of the analysis has led to the formulation of other theories. Stern (1973), however, incorporated the concept of supply elasticity in the elasticity approach.

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Elasticity Approach Contd.

According to him, devaluation could improve balance of payments only when:

where X and M are exports and imports, ED, is elasticity of demand for exports, ES, is elasticity of supply for exports, EDm is elasticity of demand for imports, and ESm is elasticity of supply for imports.

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Elasticity Approach Contd.

Based on the figures of British exports and imports, Stern has come to a conclusion that the balance of trade should improve if: 1. the elasticity of demand for exports and imports is high and is equal to one coupled with elasticity of supply both for imports and exports which is either high or low. 2. the elasticity of demand for imports and exports is low but the elasticity of supply for imports and exports is lower. On the contrary, if the elasticity of demand is low matched with high elasticity of supply, the balance of trade should worsen.

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The Keynesian View

The Keynesian view took into consideration the income effect. If there is exogenous increase in export, domestic income will rise which will lead to greater import. Greater import will match the increased export and bring back the trade balance into equilibrium. However, the achievement of equilibrium depends upon operation of the foreign trade multiplier that is in turn subject to marginal propensity to import. If the marginal propensity to consume or to import is very low, the foreign trade multiplier will be very small and income will not raise the imports as desired. Normally, in practice, owing to low marginal propensity to consume or to import, an exogenous rise in export does not bring about a comparable increase in import, and full balance of trade equilibrium is not restored.

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Absorption approach
The absorption approach is one of the earliest approaches representing the Keynesian view. Alexander (1959) treats balance of trade as a residual given by difference between what the economy produces and what it takes for domestic use or what it absorbs. He begins with the contention that the total output, Y is equal to the sum of consumption C, investment I, govt. spending G and net export (X-M). Mathematically, Y= C + I + G + ( X M ) Substituting C + I + G by absorption 'A, the above equation can be rewritten as Y=A or Y - A = X - M

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Absorption approach

Contd.

This means that the amount by which total output exceeds total spending or absorption, is represented by export over import or the net export which means a surplus balance of trade. This also means that. if A > Y, a deficit balance of trade will occur because excess absorption in absence of desired output will cause imports. Thus in order to bring about equilibrium in the balance of trade, the government has to increase output or income. Increase in income without corresponding and equal increase in absorption will lead to improvement in balance of trade. This is called the expenditure switching policy. In respect of full employment where resources are fully employed, output cannot be expanded and the balance of trade deficit can be remedied through decreasing absorption without a corresponding fall in output. This is known as the expenditure-reducing policy.

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Absorption approach

Contd.

On the contrary, where full employment is yet to be achieved, output can be increased and/or absorption can be reduced in order to bring about equilibrium in trade balance. It may be noted that the validity of the absorption approach depends upon the operation of the multiplier effect that is essential for accelerating output generation. It also depends on the marginal propensity to absorb that determines the rate of absorption, Black (1959) explains the absorption in a slightly different way. He ignores the governmental expenditure, G and equates X - M with S - I (where S is saving and I is investment.). He is of the opinion that when balance of trade is negative, the country has to increase saving on the one hand and reduce investment on the other. In case of full employment, he suggests the redistribution of national income in favour of profit earners who possess greater propensity to save.

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Absorption approach

Contd.

The impact of devaluation on the absorption can be explained broadly in three ways. First is the real balance effect. Costly imports in the sequel of devaluation raise the general price index. Under the assumption that the money stock does not change, the economic agents cut down the direct absorption in order to maintain their money balances. Second is the income distribution effect. A rise in the general price index in the wake of devaluation forces redistribution of income away from the fixed-income segment to the variable-income segment. Since the poor have a high propensity to absorb, the redistribution helps reduce the direct absorption.

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Absorption approach

Contd.

Third is the Laursen-Metzler (1950) effect. Devaluation leads to deterioration in terms of trade which in turn: 1. lowers the national income and thereby the income-related absorption; and 2. raises the consumption of domestically produced goods. While the former is the income effect, the tatter is the substitution effect. Absorption will be lower if the income effect is bigger than the substitution effect.

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Mundell-Fleming approach
Developed in the Keynesian framework, focuses through IS-LM curve on how the internal and external balance is influenced by fiscal and monetary policies. The IS curve for an open economy shows various combinations of output and interest rate. It shows: S+M=I+G+ X The left side of the equation is known as the leakages and the right side is known as the injections. Savings include autonomous savings plus savings on account of risen income based on marginal propensity to save. Imports include autonomous imports plus imports on account of risen income based on marginal propensity to import.

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Mundell-Fleming approach

Contd.

Investment is assumed to be an inverse function of rate of interest. Exports and governmental expenditure are autonomous with respect to interest rate and the level of national income. The relationship between leakages and income can be shown with an upward sloping line, whereas the injection schedule is downward sloping from left to right. The L-M schedule shows various combinations of level of income and rate of interest under the assumption that the supply of money is equal to demand for money meaning that the money market is in equilibrium. Money is demanded either for transaction purposes or for speculative purposes.

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Mundell-Fleming approach Contd.

Larger the income, bigger is the money held for transaction purposes meaning that transaction demand for money is a positive function of income. The demand for money for speculative purposes has an inverse relationship with the rate of interest. Taking together these two forms of demand, L-M schedule is upward sloping from left to right because the income levels require comparatively bigger transaction balances than the speculative balances. The balance of payments (BP) schedule shows various combinations of rate of interest and income accruing in the balance of payments. As far as current account is concerned, export is assumed to be independent of the level of national income and then rate of interest.

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Mundell-Fleming approach Contd.

But import is assumed to be positively related to income which means higher income, higher the imports and deficit is the current account. Current account deficit, if any, is offset by surplus in the capital account. Net capital account flow is positively related to the rate of interest which means higher interest rate in the country attracts inflow of capital. Thus the current account and capital account schedules slope downward from left to right.

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Mundell-Fleming approach Contd.

The balance of payments is in equilibrium because IS and LM schedules intersect at a point on the BP schedule corresponding to a given interest rate and the level of income, as shown in Figure 2.

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Mundell-Fleming approach

Contd.

If income and imports increase and interest rate decrease following an expansionary monetary policy, balance of payments will turn deficit and BP schedule will shift leftward as in Figure 3.

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Mundell-Fleming approach Contd.

On the contrary, during contractionary monetary policy regime, balance of payments will turn surplus and the BP schedule will shift rightward as in Figure 4.

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The New Cambridge School Approach

This is a special case of absorption approach. It takes into account savings (S) and investment (.I), taxes (T 1i and government spending (G), and their impact on the trade account. In the form of equation, it can be written as S+T+M=G+X +1 or (S I ) + ( T - G) + (M - X) = 0 or (X - M) = ( S I ) + (T - G) The theory assumes that (S - I) and (T - G) are determined independently of each other and of the trade gap. (S - I) is normally fixed as the private sector has a fixed net level of saving. And so the balance of payments deficit or surplus is dependent upon (T 0) and the constant (S - I). In other words, with constant (S - I), it is only the manipulation of (T - G) which is a necessary and sufficient tool for balance of payments adjustment.

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Monetary Approach

The monetarists believe that the balance of payments disequilibrium is a monetary and not structural phenomenon (Connolly, 1978). The adjustment is automatic unless the government is intentionally following an inflationary policy for quite a long period. Adjustment is brought about through making changes in monetary' variables.

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Monetary Approach

Contd.

To explain the phenomenon, it is assumed that::

 Demand for money, L, depends upon domestic price level, P and real income, Y. The relationship among these three variables does not change significantly over time. It can be written as an equation thus: L = k PY  Money supply, M, depends upon domestic credit, D, international reserves held, R and money multiplier, m. It can he written as M=(R+D)m Assuming m being equal to 1, it can be rewritten as M=R+D  Domestic price level, P depends on the foreign price level, P*, and the domestic currency price of foreign currency, E. We can write P as P = EP*  Demand for money equals the supply of money because an equilibrium is held in the money market, that is L=M

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Monetary Approach

Contd.

The process of adjustment varies among the types of exchange rate regime the country has opted for. In a fixed exchange rate regime or in gold standard, if the demand for money, that is the amount of money people with to hold is greater than the supply of money, the excess demand would be met through the inflow of money from abroad. On the contrary, with the supply of money being in excess of the demand for it, the excess supply is eliminated through the outflow of money to other countries. The inflow and the outflow influence the balance of payments. To explain it further, with constant prices and income and thus constant demand for money, any increase in domestic credit will lead to outflow of foreign exchange as the people will import more to lower the excessive cash balances.

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Monetary Approach

Contd.

As a result, the balance of payments will turn deficit. Conversely, a decrease in domestic credit would lead to an excess demand for money. International reserves will flow in to meet the excess demand. Balance of payments will improve. However, in a floating-rate regime, the demand for money is adjusted to the supply of money through changes in exchange rate. In a clean float, when the Central Bank makes no market intervention, the international reserves component of the monetary base remains unchanged. The balance of payments remains in equilibrium with neither surplus nor deficit. The spot exchange rate is determined by the quantity of money supplied and the quantity of money demanded.

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Monetary Approach

Contd.

When the Central Bank increases domestic credit through open market operations, supply of money is greater than the demand for it. The households increase their imports. With increased demand for imports, the domestic currency will depreciate and it will continue depreciating until supply of money equals the demand for money. Conversely, with decrease in domestic credit, the households reduce their import, Domestic currency will appreciate and it will continue appreciating until supply of money equals demand for money. In the case of managed floating, the Central Bank often intervenes to peg the rates at some desired level. And so this case is a mix of fixed and floating rate regimes. It means that changes in the monetary supply and demand influence not only the exchange rate but also the quantum of international reserves.

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Summary
Classical view: Self-adjusting process. Trade deficit outflow of gold decreased money supply lower prices higher exports elimination of trade deficit. Elasticity Approach (Marshall/ Lerner's view): Trade deficit devaluation (demand for export and import being price-elastic) exports cheaper abroad and higher export earnings + costlier imports and squeezed import bill elimination of trade deficit. Stern added the concept of supply elasticity meaning that supply elasticity for import and export must be favourable. Absorption Approach (Alexander's view): Trade deficit decrease in absorption (consumption + investment. + government expenditure) so that total output > absorption elimination of trade deficit.

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Summary Contd.
Black suggests for increasing saving and reducing investment, in order to , eliminate trade deficit. Mundell-Fleming view based on Adjustment in real income and nominal interest rate: Rise in interest rate lower income lower import elimination of trade deficit. Again, rise in interest rate inflow of foreign investment improvement in capital account to absorb trade deficit. New Cambridge School Approach: Greater taxes + lower governmental expenditure lower income lower import elimination of trade deficit.

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Summary Contd.
Monetary Approach: Fixed exchange rate: Reduction in credit creation decreased supply of money lower import falling trade deficit Floating exchange rate: Size of credit size of money supply exchange rate balance of trade.

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Conclusion

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