FACULTY OF MANAGEMENT STUDIES

International EconomicsWrite-up on

Disequilibrium inBalance of Payment

AndMethods to Correct it

Submitted to:

Dr. Madan Lal

Faculty of Management Studies

BHU, Varanasi.

Submitted by:

SHIVANK

Introduction

The study of the balance of payments was of great importance for the mercantilists. This

term made its entry into English economic literature during mercantilist period.

The balance of payment of a country is a systematic record of all its economic transactions

with the outside world in a given year. In the language of International Monetary Fund, “the

balance of payment for a given period is defined...as a systematic record of all economic

transactions during the period between residents of the reporting countries...”1 According

to Bo Soderson, “ The balance of payment is merely a way of listing receipts and payments

in international transactions for a contry.”2 Thus it reveals various aspects of country’s

international economic position.

A nation’s international balance of payment is in equilibrium when the autonomous supply

of and the autonomous demand for foreign exchange are equal. When a country’s

autonomous receipts (credits) do not match its autonomous payments (debits),

disequilibrium situation arises. A disequilibrium in the BOP of a country may be either a

deficit or a surplus. If autonomous credit receipts exceed autonomous debit payments,

there is a surplus in the BOP and the disequilibrium is said to be favourable. On the other

hand, if autonomous debit payments exceed autonomous debit receipts, there is a deficit in

the BOP and the disequilibrium is said to be unfavourable or adverse.

Disequilibrium in a country’s external BOP may be caused by various factors: temporal,

functional, etc. And it has important implications on a country’s economic status in the

world. Various measures are employed to correct deficit in balance of payments. All these

things will be covered in this presentation and subsequent discussion.

1. International Monetary Fund, Balance of Payments Manual, January 1950, p. 1.2. Bo Soderson, International Economics, 1980, 2/e.

2

Balance of Payments

Structure and Accounts:

The balance of payment account of a country is constructed on a double entry book-

keeping. Each transaction is entered on the credit and debit side of the balance sheet. But in

balance of payments accounting, the practise is to show credits on the left side and debits

on the right side of the balance sheet. The credit and debit items are shown vertically in the

balance of payments account of a country. Horizontally, they are divided into three

categories: the Current Account, the Capital Account, and the Official Settlement Account or

the Official Reserve Assets Account. Errors and Omissions also become a part of it.

The balance of payment of Current Account includes items like import and exports,

expenses on travel, transportation, insurance, investment income, etc. These relate

to current transactions. Both commodities and services are part of it. The difference

between exports and imports of a country is its balance of visible trade. If visible

export exceeds visible imports, the balance of trade is favourable and vice-versa. The

balance of exports and imports of services and transfer payments is called balance of

invisible trade. The net value of these visible and invisible trade balances is the

balance on current account.

The Capital Account, on the other hand, is made up of capital transactions - Private

and Government, e.g., borrowing and lending of capital, repayment of capital, sale

and purchase of securities and other assets to and from foreigners-individuals and

governments. The net value of the balances of short-term and long-term direct and

portfolio investments is the balance on capital account.

The Official Settlements Account is, in fact, a part of capital account, But the U.K. and

U.S. show it as a separate account. “The official settlements accont measures the

change in a nation’s official liquidity and non-liquid liabilities to foreign official

holders and the change in a nation’s official reserve assets during a year. The official

reserve assets of a country include its gold stock, holdings of its convertible foreign

currencies and SDRs, and its net position in the IMF.” It shows transactions in a

country’s net official reserve assets.

3

Errors and Omissions is a balancing item so that total credits and debits of the three

accounts must equal in accordance with the principles of double entry book-keeping

so that the balance of payments of a country always balances in the accounting

sense.

E.g. The balance of payments account of a country

Credits(+)(Receipts)

Exports(a) Goods(b) Services(c) Transfer Payments

(a) Borrowing from ForeignCountries

(b) Direct Investments by ForeignCountries

(a) Increase in Foreign Official Holdings

Debits(-)

(Payments)

1. Current AccountImports

(a) Goods(b) Services(c) Transfer Payments

2. Capital Account(a) Lending to Foreign

Countries(b) Direct Investments

in Foreign Countries

3. Official Settlements Account(a) Increase in Official

Reserve of Gold and Foreign Currencies

Errors and Omissions

4

Equilibrium in Balance of Payments

The balance of payments (on current account) is said to balance when the total of the credit

items is exactly equal to the total of debit items. But, it is seldom so. Hence, there is either a

deficit or a surplus in the current account of the balance of payments. This deficit or surplus

is met by transfers in the capital account. In other words, the balance of payments is made

to balance through the capital account.

Suppose there is a deficit in the current account of the balance of payment. This deficit will

be covered by

(a) Drawing upon the country’s foreign exchange reserve.

(b) By borrowing from abroad.

(c) By exporting gold.

Now the IMF grants temporary accommodation to bridge the gap.

Balance means that the algebraic sum of the net credit and debit balances of current

account, capital account, capital account and official settlements account must equal zero.

Balance of payments is written asB = Rf - Pf

Where, B represents balance of payments,Rf receipts from foreigners,Pf payments from foreigners.

When B = Rf - Pf = 0, the balance of payments is in equilibrium.When Rf - Pf > 0, there is surplus in the balance of paymentsWhen Rf - Pf < 0, there is deficit in the balance of payments

Further, say X represents exports, M imports, If foreign investment, B foreign borrowingThen if (X - M) – (If – B) = 0 The balance of payments is said to be in equilibrium

5

Disequilibrium in Balance of Payments

A disequilibrium in the BOP of a country may be either a deficit or a surplus. A deficit or

surplus in BOP of a country appears when its autonomous receipts(credits) do not match its

autonomous payments(debits). If autonomous credit receipts exceed autonomous debit

payments, there is a surplus in the BOP and the disequilibrium is said to be favourable. On

the other hand, if autonomous debit payments exceed autonomous debit receipts, there is a

deficit in the BOP and the disequilibrium is said to be unfavourable or adverse.

Types and Causes of Disequilibrium

1. Temporary Changes ( or Disequilibrium) : There may be temporary disequilibrium

due to random variables in trade, seasonal fluctuations, the effects of weather on

agricultural production, etc. Deficits or surplus arising from such causes are expected

to correct themselves within a short time.

2. Fundamental Disequilibrium : It refers to persistent and long run BOP disequilibrium

of a country. It is a chronic BOP deficit, according to IMF. It is caused by dynamic

factors as:

a) Change of consumer taste within the country or abroad which leads to

increase on imports and decrease in exports.

b) Continuous fall in country’s foreign exchange reserves due to supply

inelasticity of export and excessive demand for foreign goods.

c) Excessive capital outflow due to massive imports of capital goods, raw

materials, technology, essential consumer goods, and external

indebtedness.

d) Low competitive strengths in world markets which adversely affects

exports.

e) Inflationary pressures within the economy which makes exports dearer.

6

3. Structural Changes (or Disequilibrium) : Structural disequilibrium can be further

Bifurcated into:

a) Structural Disequilibrium at Goods Level: Structural

disequilibrium at goods level occurs when a change in demand or

supply of exports or imports alters a previously existing

equilibrium, or when a change occurs in the basic circumstances

under which income is earned or spent abroad, in both cases

without the requisite parallel changes elsewhere in the economy.

b) Structural Disequilibrium at Factors Level: Structural

disequilibrium at the factor level results from factor prices which

fall to reflect accurately factor endowments, i.e., when factor

prices are out of line with factor endowments, distort the structure

of production from the allocation of resources which appropriate

factor prices would have indicated.

4. Cyclical Fluctuations (or disequilibrium) : Cyclical disequilibrium occurs because of

two reasons. First, two countries may be passing through different paths of business

cycle. Second, the countries may be following the same path but the income

elasticity of demand or price elasticity of demand is different. If prices rise in

prosperity and decline in depression, a country with a price elasticity for imports

greater than unity will experience a tendency for decline in the value of imports in

prosperity; while those for which import price elasticity is less than one will

experience a tendency for increase. (These tendencies may be overshadowed by the

effects of income changes, of course. Conversely, as prices decline in depression, the

elastic demand will bring about an increase in imports, the inelastic demand a

decrease. )

5. Changes in Exchange rate: Changes in forex rate due to over or under valuation of

foreign currency leads to BOP disequilibrium. When the value of a currency is higher

in relation to foreign currency, it is said to be overvalued and vice-versa.

7

Overvaluation of domestic currency makes foreign goods cheaper and exports

dearer in foreign countries. As a result, country imports more and exports less of

goods. There is also outflow of capital. This leads to unfavourable BOP. On the

contrary, undervaluation makes BOP favourable by encouraging exports and inflow

of capital and reducing imports.

6. Changes in National Income : If the national income increases, it will lead to an

increase in imports thereby creating a deficit in balance of payments, other things

remaining the same. If the country is already at full employment level, an increase in

incomes will lead to inflationary pressure which may increase its imports resulting in

adverse balance of payments.

7. Price Changes: If there is inflation in the country, price of exports increase. As a

result, exports fall and at the same time, the demand for imports increases. Thus

again leading to an adverse balance of payments situation.

8. Stage of Economic Development: If a country is developing, it will have a deficit in

its BOP because its imports raw material, machinery, capital equipment and services

associated with the development process. It exports only primary products, thus it

has to pay more for costly imports and gets less for basic exports.

9. Capital Movements: Borrowing and lending also result in disequilibrium of BOP. A

country which gives loans and grants on a large scale to other countries has a deficit

in its BOP on capital account. If it is also importing more, as is the case with the USA,

it will have chror deficit. On the other hand, a developing country borrowing large

funds from other countries and international institutions may have a favourable

BOP. But such a case is remotely possible because these countries usually imports

huge quantities of food, raw materials and capital goods, etc and export primary

products. Such borrowings simply help in reducing BOP deficit.

10. Political Conditions: Political instability in a country creates uncertainty in foreign

investors which leads to the outflow of capital and retards its inflows thus creating

disequilibrium. It may also occur in case of war or fear of war.

8

Measures to Correct Deficit in Balanced of Payments

To correct the different types of disequilibrium in BOP the following general measures are

used:

1) Exchange depreciation (price effect) or devaluation (by government),

2) Deflate the currency,

3) Tariffs,

4) Import quotas, and

5) Export duties.

1) Exchange Depreciation (Price Effect) or Devaluation (by Government): Exchange

depreciation means a reduction in the value of a currency in terms of gold or other

currencies under ‘free market’ conditions and coming about through a decline in the

demand for that currency in relation to the supply. This is usually applied to ‘ floating

exchange rates’ . The purpose of this method is to depreciate the external exchange

value of the home currency, thus cheapening the domestic goods for the foreigner .

Whereas, under ‘fixed-parity system’ or ‘fixed exchange rate’, the reduction of

currency value in against the gold or other currencies is official and not market

based. This official reduction of exchange rate is called ‘devaluation’. The purpose of

both ‘depreciation’ and ‘devaluation’ is to cheapen the domestic goods and boost up

the exports. (But the governments regarded devaluation as a means of correcting a

balance of payments deficit only as a measure of last resort. They predominantly

relied on deflation of the home market and international borrowing. Devaluation or

depreciation of the exchange rate can correct a balance of payment deficit because

it lowers the price of exports in terms of foreign currencies and raises the price of

imports on the home market. This does not necessarily succeed in its purpose. The

immediate effect is similar to an unfavourable change in the TOT. For the resources

9

devoted to the production of exports, less foreign exchange is earned with which to

pay for imports. If the level of imports remained the same, more output would have

to be diverted to exports and away from home consumption and investment simply

to maintain the status quo. Devaluation or depreciation could lead to a loss of real

income without any benefit to the balance of payments. )

Pakistan has always faced negative BOT except for three years, i.e. 1947-48, 1950-51 and

1972-73. The newly born Pakistan had a quite high exports and a handsome balance of

trade (US $ 42 million). With the Korean War boom in 1950-51, once again Pakistan gained

a surplus in BOT (US $ 53 million). However, the reason for 1972-73’s positive BOT ($ 20

million) was the massive currency devaluation in 1972 when the rupee was devalued from

Rs. 4.76 to 2.3 times higher level of Rs. 11 per US dollar. The exports increased significantly

and the share of exports in GDP rose to 14.9%.

2) Deflate the Currency: According to this method, the currency is deflated. As the

currency contracts, prices will fall, which will stimulate exports and check imports.

But the method of deflation is also full of dangers. If prices are forced down while

costs, which are proverbially rigid (especially as regards wages in countries where

trade unions are well organised), do not follow suit, the country may face a serious

depression and unemployment. Correcting the balance of payments, therefore, once

a disequilibrium has arisen is not an easy matter.

3) Tariffs: Tariff is a tax levied on imports. It is synonymous with import duties or

custom duties. Tariffs are used for two different purposes; for revenue and for

protection.

‘Revenue Tariffs’ are a source of government revenue

‘Protective Tariffs’ are meant to maintain and encourage those branches of

home industry protected by the duties.

10

Tariff duties are of four types:

Ad Valorem Tariff: It is levied as a percentage of the total value of the imported

commodity.

Specific Duties: These are levied per unit of the imported commodity.

Compound Duties: These are a mixture of above two.

Sliding Scale Duties: These vary with the prices of commodities imported.

4) Import Quotas: As a protective device, import quotas are alternative to tariffs.

Under an import quota, fixed amount of a commodity in volume or value is allowed

to be imported into the country during a specified period of time. The major

objectives of import quotas are:

to avoid foreign competition,

to provide greater administrative flexibility,

to solve the problem of BOP and BOT.

Import quotas are of the following five types:

Tariff quota,

Unilateral quota,

Mixing quota,

Bilateral quota, and

Import licensing.

5) Export Duties: When world prices are higher than domestic prices, there is an

incentive to export. In such a situation, a government may levy export duties.

11

Export duties are used to prevent exports. The reason may be that exported

commodities are required domestically.

Conclusion

In short, correction of disequilibrium calls for a judicious mix of the following methods:

a) Monetary and fiscal changes affecting income and price in the country;

b) Exchange rate adjustment, i.e., depreciation or appreciation of the home currency;

c) Trade restrictions, i.e., tariffs, quotas, etc.;

d) Capital Movements, i.e., borrowing or lending abroad.

No reliance can be placed on any single tool. There is room for more than one approach and

for more than one device. But the application of the tool depends on the nature of

disequilibrium. There are four types of disequilibrium, two in income (cyclical and secular)

and two in prices or structural (at the goods and factor level). It is more appropriate that the

cyclical and secular disequilibria be tackled by monetary and fiscal measures. In structural

disequilibria, exchange rate adjustment plays a greater role. Generally, trade restrictions

should be avoided. Capital movements by time in short-run disturbances and are needed to

offset deep-seated forces in secular disequilibrium.

The main methods of desirable adjustments are, therefore, a monetary and fiscal policy

which directly affects income, and exchange depreciation which affects prices in the first

instance. It can also have income effect through price effects. Monetary and fiscal policies

affect relative prices also.

12

Multiple Choice Questions

1. A nation has a surplus in its balance of payments if its total credits exceed its total ________ in its current and capital accounts.

a) Debits

b) Reserves

c) Exports

d) Imports

2. A deficit in a nation’s balance of payments is corrected by a depreciation of its currency under a ____________?

a) Fixed-parity exchange-rate system

b) Floating exchange-rate system

c) Both (a) and (b)

d) None of these.

3. A current account deficit is financed through ___________?

a) Exports

b) Lending money to foreign countries

c) borrowing or foreign investment

d) All of the above

4. Transaction are said to be autonomous if their value is determined ____ of the BOP.

a) Independently

b) Dependently

c) Accommodating

13

d) Exclusive

Answers: 1) a 2) b 3) c 4) a

Short Answer Type Questions

1) What happens to the equilibrium rate of exchange and to the equilibrium

Quantity of foreign exchange if the nation’s demand for the foreign currency

Decreases? Why?

1) Given the nation’s supply curve of the foreign currency, a downward shift in the

nation’s demand curve for the foreign currency will determine a new and lower

equilibrium exchange rate and equilibrium quantity. A decrease in the nation’s

demand for a foreign currency may result from a change in tastes for less imported

goods and services. It may also occur if the nation decreases its investments and

loans abroad in the expectation of decreased returns.

2) How is a deficit or a surplus in a nation’s balance of payments corrected

Under a flexible-exchange-rate system?

2) A deficit in a nation’s balance of payments means that at a given rate of exchange,

there is a shortage (an excess of quantity demanded over quantity supplied) of the

foreign currency. If the exchange rate is freely flexible or floating, the exchange rate

will rise until the quantity demanded of the foreign currency equals the quantity

supplied and the deficit is completely eliminated. This rise in the exchange rate

means that the relative value of the domestic currency is falling or depreciating. The

Exact opposite occurs when there is a surplus and the nation’s currency appreciates

(Or increases) in relative value.

3) What is a Balance of payments crisis

3) A BOP crisis, also called a currency crisis, occurs when a nation is unable to pay for

essential imports and/or service its debt repayments. Typically, this is accompanied

14

by a rapid decline in the value of the affected nation's currency. Crises are generally

preceded by large capital inflows, which are associated at first with rapid economic

growth. However a point is reached where overseas investors become concerned

about the level of debt their inbound capital is generating, and decide to pull out

their funds. The resulting outbound capital flows are associated with a rapid drop in

the value of the affected nation's currency. This causes issues for firms of the

affected nation who have received the inbound investments and loans, as the

revenue of those firms is typically mostly derived domestically but their debts are

often denominated in a reserve currency. Once the nation's government has

exhausted its foreign reserves trying to support the value of the domestic currency,

its policy options are very limited. It can raise its interest rates to try to prevent

further declines in the value of its currency, but while this can help those with debts

in denominated in foreign currencies, it generally further depresses the local

economy.

4) Is a Current Account Deficit a bad Thing?

4) A Current account is considered harmful to the economy because:

a. A current account deficit is financed through borrowing or foreign investment

b. Borrowing is unsustainable in the long term and countries will be burdened with high

interest payments. E.g Russia was unable to pay its foreign debt back in 1998. Other

developing countries have experience similar repayment problems Brazil, African

countries (3rd World debt)

c. Foreigners have an increasing claim on country’s assets, which they could desire to

be returned at any time. E.g. a severe financial crisis in Japan may cause them to

repatriate their investments.

d. Export sector may be better at creating jobs

e. A Balance of Payments deficit may cause a loss of confidence

However a current account deficit is not necessarily harmful

a. Current Account deficit could be used to finance investment e.g. US ran a Current

account deficit for a long time as it borrowed to invest in its economy. This enabled

higher growth and so it was able to pay its debts back and countries had confidence

in lending the US money.

15

b. With a floating exchange rate a large current account deficit should cause a

devaluation which will help reduce the level of the deficit.

Thus, It depend on the size of the budget deficit as a % of GDP.

Bibliography

Schaum’s Outline of Theory and Problems of Principles of Economics (Second Edition) By Dominick Salvatore , Eugene A . Diulio

International Economics (Sixth Edition)By M.L. Jhingan

Modern Economic Theory (23rd Edition)By Dr. K.K. Dewett and M.H. Navalur

International EconomicsBy M.C. Vaish and S Singh

16