BALANCE OF PAYMENT

A systematic record of all economic transactions between the

residents of a country and residents of foreign countries.

The balance of payments serves a very useful purpose in so far as

it yields necessary Purpose information for the formulation of
future policy in regard to domestic monetary, fiscal and foreign
trade policies. The major uses of BOP accounts are the following:-

First, the balance of payments accounts provide extremely useful

data for the economic analysis of the country's weakness and
strength as a partner in international trade.

Second, balance of payments also reveals the changes in the

composition and magnitude of foreign trade. The changes that are
a deterrent to the economic well being of the country call for
necessary action by the government.

Third, balance of payments also provides indications of future

repercussions of country's past trade performances. If balance of
payments shows continuous and large trade deficits over time, it
shows the growing international indebtedness of the country,
which may ultimately lead to financial bankruptcy.

A continuous large scale surplus in the balance of payments,

particularly when its magnitude goes beyond the absorption
capacity of the country, indicates impending danger of high
inflation.

Finally, detailed balance of payments accounts reveal also the

weak and strong points in the country's foreign trade relations and
thereby invites government attention to the need for corrective
measures against the weak spots and unhealthy developments.
 Balance of Payments Accounts
The economic transactions between a country and the rest of the
world may be grouped under two broad categories:
(1) current transactions :- Export and import of merchandise
and service. Current transactions pertain to export and
import of goods and services that change the current level
of consumption in the country or bring a change in the
current level of national (money) income

(2) capital transactions :- Capital transactions are those which

increase or decrease a country's total stock of capital,
instead of affecting the current level of consumption or
national income, accordance with the two kinds of
transactions, balance of payments accounting divided into
two major accounts:-
(1) current accounts
(2) capital accounts.

Current Account
The items listed in current account can be further grouped as :-
(1) Visible items
(2) Invisible items.
Merchandise trade, export and import of goods, falls under the
visible item. Other items in the current account payment and
receipt for the services, such as banking insurance and
shipping etc..

The Net balance on the visible items, i.e., the excess of

merchandise expert (Xg) over the merchandise imports (Mg) is
called balance of trade. If Xg > Mg the balance of trade is said to be
favorable and if Xg < Mg, it is unfavorable. The overall balance on
the Current Account—surplus or a deficit is carried over to the
Account.
BALANCE OF PAYMENT (CURRENT ACCOUNT)

s.no Transactions Credit Debit Net Balance

1. Merchandise Export Import 1

2. Foreign travel Earning Payments

3. Transportation Earnings Payments
4. Insurance Receipts Payments —
(Premium)
5. Investment Dividend Dividend
income
Receipts Payments
6. Government
(purchase and Receipt Payment —
sales of goods
and services)
7. Miscellaneous Receipt Payment —
Current A/C — — Surplus (-!-)
Balance
Deficit (-)
 Capital Account

The Capital Account of the balance of payment or those which

affect the existing stock of capital of the count broad categories of
capital account items are:
(a) short-term capital movements
(b) long-term capital movements
(c) changes in the gold and exchange

Short-term capital movements include

(1) purchase of short-term securities such as treasury bills,

commercial bills and acceptance bills.
(2) speculative purchase of foreign currency
(3) cash balances held by foreigners for such reasons as fear of
war, political instability, etc. Another item of short-term capital is
the net balances (positive or negative) in the Current Account.

Long-term capital movements include

(1) Direct investments in shares bond and in real estate and

physical assets such as plants, buildings, equipments,
(2) Portfolio investments in stocks and bond. such as government
securities, securities of firms not entitling the holder with a
controlling power
(3) Amortization of capital, i.e., repurchases and resale of
securities earlier sold to or purchased from the foreigners.
Direct export or import of capital goods fall under the
category of direct investment and are treated as such.

It is important to note here that export of capita! is a debit Item

and import of capital is a credit item whereas export of
merchandise is a credit item and import of merchandise is a debit
item.

Gold and foreign exchange

Gold and foreign exchange reserves make the third major category
of items in the capital account. Gold and foreign exchange reserves
are maintained to stabilize the exchange rate of the home currency
and to make payments to the creditors in case there exist payment
deficits on all other accounts.

Disequilibrium in Balance of Payments

Disequilibrium in the balance of payments does arise because total

receipts during the reference period need not always necessarily be
equal to the total payment obligations of that period. When total
receipts do not match with total payment obligations of the
accounting period, this is a position of disequilibrium in the
balance of payments.

For the purpose of assessing the overall balance of payments

position of the country the total receipts and total payments arising
out of transfer of goods and services and long-term capital
movements, and all other transactions are regrouped under tie
following two categories:
(a) Autonomous transactions.
(b) Induced transactions or accommodating capital flows.

Autonomous transactions

Autonomous transactions, All exports and imports of goods and

services, long-term and short-term capital movement motivated by
the desire to earn higher returns abroad or to give gifts and
donation etc., are the autonomous transactions.

Induced transactions

Induced transactions, The short-term capital, movements, gold

movements and accommodating capital movements on account of
the autonomous transactions are induced transactions.

Causes and Kinds of BOP Disequilibrium

The total import of a country depends on three factors:

(1) internal demand for foreign goods, which depends largely on
the total purchasing power of the residents of the importing
country.
(2) The relative prices of imports and their domestic substitutes.
(3) people's preference for foreign goods.
(4) price-elasticity of demand for imports and
(5) income-elasticity of imports.

The total export of a country depends on

(1) foreign demand for its goods,
(2) competitiveness of its price and quality and
(3) its exportable surplus.

Kind and the causes of disequilibrium

1.Price Changes and Fundamental Disequilibrium. The first

and a major cause of disequilibrium in the balance of payments is
the change in the price level. The change in the price level may be
inflationary or deflationary, loss 01 employment, distortions in the
domestic economy and cause other economic problems in the
deficit countries. We will, therefore, discuss here only the impact
of inflationary' price changes on the balance of payments position.

If inflationary conditions perpetuate due to some in-built

fundamental imbalances in the economy, it produces a
long-run disequilibrium. the size of deficit is large and
disequilibrium is obdurate, it is called fundamental
disequilibrium.
2. Business Cycles and Cyclical Disequilibrium, Business cycles
are characterized by economic ups and downs. The economic ups
and downs are often associated with inflationary rise or
deflationary decline in the general price level, respectively.
Deficits and surpluses in the balance of payments vi from moderate
to large. The countries with higher marginal propensity to import
accumulate larger deficits during inflationary phase of a trade
cycle and a moderate deficit, or even a surplus, during the period
of depression. Such disequilibria are known as cyclical
disequilibria.
3. Structural Changes and Structural Disequilibrium.
Structural changes in an economy are caused by such factors as
(1) Depletion of the cheap natural resources.
(2) Change in technology with which a country is not in a position
to keep pace; Technology lag.
(3) Change in consumers' taste and preference.

A change in demand and supply conditions. If the size of foreign

trade is fairly large, then the balance of payments is adversely
affected. The ultimate result is disequilibrium in the balance of
payments. It is called structural disequilibrium.

The structural disequilibrium may also originate from the

discovery of new resources which may invite foreign capital in a
large measure. The large scale capital inflow may turn the balance-
of-payments deficit into a surplus.

4. Other Factors Causing Disequilibrium. In addition to the

fundamental factors responsible for disequilibrium in the balance
of payments, there are certain other factors which may cause
temporal or short-run disequilibrium. Some of them are:

(1) Rapid growth in population leading to large scale imports of

food grains or wage goods
(2) Ambitious development programmes requiring heavy imports
of technology, equipment, machinery and technical know-
how.
(3) Demonstration-effect of advanced countries on the
consumption pattern of the people in less developed
countries.
\
 Balance of Payments Adjustments

The measures that are generally adopted to correct the BOP

disequilibrium can be classified as follows:
(1) Policy measures
(2) Direct control measures.

There for generally two kinds of policy measures are adopted:

(1) Income related measures
(2) Price related measures.

Income Related Policies: Demand may be reduced through a

change in its main determinants, income and price reduction in
income can lead to reduction in demand.

The two policy change disposable income:-

Monetary Policy The instruments of monetary policy include
discount rate policy, open market operations, statutory reserve
ratio, and selective credit controls.

Fiscal Policy Fiscal policy as a tool of changing household

incomes includes variation in
(1) Taxation
(2) Public expenditure.

Taxation reduces household disposable income. Direct taxes

directly transfer the household incomes to the public coffers and
thus reduce the overall demand for consumer goods, both domestic
and imported. Direct taxes reduce personal savings directly in a
good measure while indirect taxes do it in a relatively small
measure. Taxation can be used to curtail investment by taxing
capital incomes at progressive rates. As regards the indirect taxes,
e.g.. sales tax and excise duty, their effect on imports is uncertain.
public expenditure The government can reduce income and
demand by adopting a policy of surplus budgeting, i.e.. the
government keeps its expenditure less than its revenue. When the
government adopts a surplus budget policy, it increases tax rates
and reduces public expenditure.

(1) Price Measures: Exchange Depreciation and Devalution,

Reducing demand for imports through price measures requires
changing the relative prices of imports and exports. Relative prices
of imports and exports can be changed through
(a) Exchange depreciation and
(b) Devaluation.

Exchange depreciation refers to a fall in the market value of

home currency in terms of foreign currency and devaluation refers
to government's deliberate devaluation of home currency in terms
of gold and reserve currency.

Devaluation or exchange depreciation are achieved or not depends

on the following conditions:-

First, the most important condition in this regard is the Marshall-

Lerner condition. The Marshall-Lerner condition states that
devaluation will improve the balance of payments only if the sum
of elasticites of home demand for imports and that of foreign
demand for its exports is greater than unit. If the sum of
elasticities is less than unity, the balance of payments can be
improved through revaluation instead of devaluation.

Secondly, devaluation can be successful only if the affected

countries do not devalue their currency in retaliation.

Thirdly, devaluation must not change the cost-price structure in

favour of imports.
Finally, the government must ensure that inflation, which may be
the result of devaluation, is kept under control, so that the effect of
devaluation is not counterbalanced by the effect of inflation,^