Lecture-9: Balance of Payments-

Causes of Disequilibrium, Approaches

to BoP Policy- Traditional, Absorption
and Monetary Approach
Unit-5: International Economics
NTA-UGC-NET
Economics (Paper-2)
 Balance of Payments

BoP Definition
• BOP is a systematic record of all international economic transactions, visible as well as invisible of a
country during a given period, usually a year.
• BOP statement is a device for recording all the economic transactions within a given period of time
between the residents of a country and the residents of other countries.
• Since it records transactions during a period of time, so it is a flow concept.
• Transactions in which domestic residents either purchase assets (goods and services) from abroad or reduce
foreign liabilities are considered uses (outflow) of funds because payments abroad must be made.
• Transactions in which domestic residents either sell assets to foreign residents or increase their liabilities to
foreigners are sources (inflows) of funds because payments from abroad are received. Thus, in a way, it
resembles a company's sources and uses of funds statement.
 Balance of Payments

BoP Accounting
The balance of payment is a standard double-entry accounting record and as such subject to all the rules of double-entry
book-keeping viz. for every transaction, two entries must be made. One credit (+) and one debit (-) and leaving aside errors
and omissions, the total of credits must exactly match the total of debits i.e. the balance of payments must always balance.
BoP Rules
The following rules are adhered to while recording transactions in a nation’s BOP:
a) All transactions which lead to immediate or prospective payment from ROW to a country are recorded as a credit. Ex-
payments received for exports of goods and services as also loans received abroad or inward foreign investment-whether
direct or portfolio would be credit items [All DOLLAR INFLOWS]
b) Conversely, all transactions which result in an actual or prospective payment from the country to the rest of the world
should be recorded as debits. [All DOLLAR OUTFLOWS]
c) A transaction which results in an increase in demand for foreign exchange is to be recorded as debit entry while a
transaction which results in an increase in the supply of foreign exchange is a credit entry
 BoP Components: Current Account
I. Current Account: Includes imports and exports of goods and services and unilateral transfers (unrequited payments or
receipts), which reflect government and private gifts and grants of a nation during an accounting period. It is a flow
concept.
The current account of the BOP can be broken in two parts.
(a) Balance of Trade [Merchandise Trade]: Deals only with exports and imports of merchandise (or visible items).
i) Deficits in BOT; these will occur. When X < M ;
ii) Surplus in BOT; these will occur. When X>M;
iii) Balance of BOT; these will occur. When X = M
Merchandise exports are valued on F.O.B. (Free on board) basis, on private and government account are the credit
entries data for these items. They are calculated from the various documents exporters fill and submit to designated
authorities.
Merchandise imports are valued at C.I.F. (Cost, Insurance and Freight) are the debit entries.
The difference between the totals of credits and debits appears in the 'Net' column. This is the balance on
Merchandise Trade Account, a deficit, if negative and a surplus if positive
 BoP Components: Current Account
(b) Balance of Trade in Services (BoS) [Invisibles]: It shows net receipts on account of trade in services, (invisibles).
Invisibles can be classified as:
i) services, such as banking, insurance, shipping civil aviation, royalty, consultancy services, postal services, etc.
ii) investment income, which includes profits and dividends on direct, portfolio and other investments as well as interest
charges on bilateral and multilateral loans.
iii) travel both business and tourist,
iv) government transfers, and v) private transfers.
Payments received against services provided by Indians to the ROW are called current receipts- Credit Item, for example-
interests, dividends, factor incomes received by residents from ROW, income earned from the use by non-residents of non-
financial assets such as patents, copyrights owned by the residents, gifts received by the residents from non-residents, etc.
Payments made for services received from ROW by India are called current payments- Debit Item.
i) Deficits in BOS; these will occur. When R< P ;
ii) Surplus in BOS; these will occur. When R>P; and
iii) Balance in BOS; these will occur. When R=P
 BoP Components: Current Account
Balance on Current Account = BOT + BOS.
Balance on the current account is the net of all current foreign exchange earnings of a country during a year and its
liabilities in the form of foreign exchange expenditure during the year.
Balance on Current Account or Current Account Balance can have any of these status.
a. Current Account Deficits: When imports > exports.
b. Current Account Surplus: When imports < exports.
c. Current Account Balance: When imports. = exports.
 BoP Components: Capital Account
II. Capital Account:
• Includes transactions leading to changes in foreign financial assets and liabilities of a nation during an accounting
period. Hence, it is a flow concept.
• Capital Account records the changes in the levels of international financial assets and liabilities.
• It also distinguishes between short-term and long-term capital flows, loans with a maturity of more than one year are
classified as long-term flows.
• Long-term foreign investment measures all capital investments made between countries, including both direct foreign
investment and purchases of securities with maturities exceeding one year.
• Short-term foreign investment measures the flow of funds invested in securities with maturities of less than one year.
 BoP Components: Capital Account
(a) Private Capital Flows:
• Long-term loans received by individuals and companies (other than banking institutions), investment by foreigners
in the joint stock companies in India, repayment of long-term loans by the non-residents, obtained from residents,
repatriation of Indian investments abroad, deposits in non-resident (external) rupee accounts and in foreign
currency non-resident accounts.
• Capital outflows (debit entries) comprise investments by residents in shares and other financial assets abroad,
repayment of foreign loans by residents, repatriation of foreign investments in India, long-term loans made to non-
residents and so forth.
• Short-term capital flows on private account consists of short-term borrowings and investments.
 BoP Components: Capital Account
(b) Banking:
• Capital movements in banking sector covers changes in foreign assets and liabilities of commercial banks, whether
privately owned or government owned and cooperative banks.
• Assets consist of balances held by banks with their foreign branches or correspondent banks abroad, and rupee
assets representing loans granted by Indian banks to branches of foreign banks in India and correspondent banks.
• Liabilities consist of Indian banks' debit balances in their foreign accounts and credit balances held by non resident
banks and few other institutions with banks in India.
• Any increase in assets (or decrease in liabilities) will be a debit entry while a decrease in assets (or increase in
liability) a credit.
(c) Official Capital Flows:
• It covers transactions affecting foreign financial assets and liabilities of the government of India and the Reserve
Bank of India, excluding transactions relating to official reserve assets.
• The Government of India's purchase and repurchase from the IMF are shown in a separate account (next slide).
• Loans received by the Government of India from Capital Account. foreign governments and international
institutions are treated as credit entries and amortisation or repayment of such loans as debit.
 BoP Components: Other Accounts
III. The Other Accounts:
a. The IMF account contains, purchases (credits) and repurchases from the IMF.
b. SDRs (Special Drawing Rights) are a reserve asset created by the IMF and allocated to member countries from time to
time. Subject to IMF regulations, SDRs can be used to settle international payments between monetary authorities of
member countries. An allocation is a credit and the utilisation is a debit.
c. The Reserves and Monetary Gold account increases (debits) and decreases (credits) in reserve assets. Reserve assets
consist of RBI holdings of gold and foreign exchange (in the form of balances with foreign central banks and investments
in foreign governments securities) and Government's holdings of SDRs.
In principle, reserve account is not different from the capital account in as much as it relates to financial assets and
liabilities. However, in this category, only reserve assets are included. These are the assets which the central bank of the
country uses to settle deficits & surpluses that arises in other two categories.
 BoP Components: Other Accounts
For Illustration Purpose Only
 BoP Components: Other Accounts
While changes in reserve assets are accurately measured, recording of other items is subject to errors arising out of data
inadequacies, discrepancies of valuation and timing, erroneous reporting etc. These are reconciled through a fictitious head
of account called 'Errors and Omissions’.
• It reflects transactions that have not been recorded for various reasons and so cannot be entered under a standard
heading, but which we know must appear since the full BoP account must sum to zero; and changes in official reserves
and in official liabilities that are part of the reserves of other countries.
• Errors and omissions (or the balancing items) reflect the difficulties involved in recording accurately, if at all, a wide
variety of transactions that occur within a given period (usually 12 months).
• It may also include those cases where, problems arise when one or other of the parts of a transaction takes more than
one year.
• Cases like smuggling, where merchandise side of the transaction is unreported although payment will be made
somehow and will be reflected somewhere in the accounts. Similarly, the desire to avoid taxes may lead to under-
reporting of some items in order to reduce tax liabilities.
 BoP Components: Other Accounts
Reserves are held in three forms-
• in foreign currency, usually but not always the US dollar,
• as gold, and
• as Special Drawing Rights (SDRs) borrowed from the IMF.

The changes in the country's reserves must of course reflect the net value of all the other recorded items in the balance of
payments. These changes in reserves will of course be recorded accurately, and it is the discrepancy between the changes
in reserves and the net value of the other recorded items that allows us to identify the errors and omissions
BoP Components: Questions
 BoP Components: Questions
Question-2: GATE Economics 2020
Accommodating versus Autonomous Items
 Accommodating versus Autonomous Items

1. Autonomous transactions (self-motivated) take place on their own, in response to their felt needs and are
independent of situation in the balance of payments. These transactions take place automatically due to
natural human need and desire for consuming more and better goods and to earn more and more profits.

2. Accommodating or financing transactions or induced transactions or compensatory items refer to the

flows which take place in response to surplus or deficit in the balance of payments. For example, a country
may incur or raise its liabilities or reduce its assets in order to pay for the deficit. A deficit in balance of
payment exists when payments for autonomous or self-motivated transactions exceed receipts. In case,
there is a deficit or surplus, there have to be some compensatory transactions to balance the imbalance.
Autonomous and financing transactions are also referred to as above the line ad below the line
respectively.
 THE BASIC BALANCE
The Basic Balance = CURR A/c Balance + Net Balance on Long-Term Capital [i.e. items placed 'above the line’].
• A worsening of the basic balance (an increase in a deficit or a reduction in a surplus, or even a move from surplus to
deficit) is seen as indicating a deterioration in the (relative) state of the economy.
• Changes in the compensatory items are made so as to offset the surplus or deficit in the autonomous items.
• Thus, when autonomous movements cancel out over some appropriate time period and there is no need for
compensatory movements, the balance of payments is in equilibrium.
 THE BASIC BALANCE
The Basic Balance = CURR A/c Balance + Net Balance on Long-Term Capital [i.e. items placed 'above the line’].
• A worsening of the basic balance (an increase in a deficit or a reduction in a surplus, or even a move from surplus to
deficit) is seen as indicating a deterioration in the (relative) state of the economy.
• Changes in the compensatory items are made so as to offset the surplus or deficit in the autonomous items.
• Thus, when autonomous movements cancel out over some appropriate time period and there is no need for
compensatory movements, the balance of payments is in equilibrium.
(X – M) + LTC = 0
Where, X: Exports including invisible items, | M stands for imports including invisible items, LTC stands for long-term
capital movements.
⮚ When (X – M) > 0 (i.e., X > M), then for BoP to be in equilibrium, LTC will be negative and equal to (X – M). This
implies that there will be net capital outflow.
⮚ When (X – M) < 0 (i.e. M > X), then for BoP to be in equilibrium LTC must be positive (that is, there will be net
capital inflow to offset the deficit in the current account).
⮚ When balance of payments of a country is in equilibrium, the demand for the domestic currency is equal to its supply.
 THE BASIC BALANCE
Alternatively
• An alternative approach is to consider whether the net monetary transfer that has been made by the monetary authorities
is positive or negative - the so-called settlements concept.
• If the net transfer is negative (i.e. there is an outflow) then the balance of payments is said to be in deficit, but if there is
an inflow then it is in surplus.
• The basic premise is that the monetary authorities are the ultimate financiers of any deficit in the balance of payments
(or the recipients of any surplus).
• These official settlements are thus seen as the accommodating item, all others being autonomous.
• The monetary authorities may finance a deficit by depleting their reserves of foreign currencies, by borrowing from the
IMF, or by borrowing from foreign monetary authorities.
• The settlements approach is more relevant under a system of pegged exchange rates than when exchange rates are
floating.
 Approaches to Balance of Payments
(Adjustments to BoP policy)
There are three approaches to BoP policy
• Elasticity Approach
• Absorption Approach or Keynesian Approach
• Monetary Approach
 Approaches to Balance of Payments
Elasticity Approach: Marshall-Lerner Condition:
The elasticity approach to BOP is associated with the Marshall-Lerner condition which was worked out independently by
these two economists. It studies the conditions under which exchange rate changes restore equilibrium in BOP by devaluing
a country’s currency. This approach is related to the price effect of devaluation.

Assumptions:
1. Supplies of exports are perfectly elastic.
2. Product prices are fixed in domestic currency.
3. Income levels are fixed in the devaluing country.
4. The supply of imparts are large.
5. The price elasticities of demand for exports and imports are arc elasticities.
6. Price elasticities refer to absolute values.
7. The country’s current account balance equals its trade balance
 Approaches to Balance of Payments
Elasticity Approach: Marshall-Lerner Condition:
Given these assumptions, when a country devalues its currency, the domestic prices of its imports are raised and the foreign
prices of its exports are reduced. Thus devaluation helps to improve BOP deficit of a country by increasing its exports and
reducing its imports.
But the extent to which it will succeed depends on the country’s price elasticities of domestic demand for imports and
foreign demand for exports. This is what the Marshall-Lerner condition states: when the sum of price elasticities of demand
for exports and imports in absolute terms is greater than unity, devaluation will improve the country’s balance of
payments, i.e.
Ex + Em > 1
Where, Ex is the demand elasticity of exports and Em is the demand elasticity for imports.
On the contrary,
if the sum of price elasticities of demand for exports and imports, in absolute terms, is less unity,
Ex + Em < 1,
devaluation will worsen (increase the deficit) the BOP. If the sum of these elasticities in absolute terms is equal to unity, Ex
+ Em = 1, devaluation has no effect on the BOP situation which will remain unchanged.
 Approaches to Balance of Payments
Elasticity Approach: Marshall-Lerner Condition: PROCESS
Devaluation → Domestic prices of exports in terms of the foreign currency  → Exports increase.
The extent to which they increase depends on the demand elasticity for exports, nature of goods exported and the market
conditions.
• If the country is the sole supplier, exports raw materials or perishable goods, LOW Demand Elasticity for its exports→
Devaluation is not so successful
• If it exports machinery, tools and industrial products in competition → HIGH Demand Elasticity → Devaluation will be
successful in correcting a deficit.
 Approaches to Balance of Payments
Elasticity Approach: Marshall-Lerner Condition: PROCESS
Devaluation → Raises domestic price of imports → Reduces the demand for import.
By how much the volume of imports will decline depends on the demand elasticity of imports.
The demand elasticity of imports, in turn, depends on the nature of goods imported by the devaluing country.
• If it imports consumer goods, raw materials and inputs for industries → LOW Elasticity of demand for imports
• It is only when the import elasticity of demand for products is high that devaluation will help in correcting a
deficit in the balance of payments.
• Thus it is only when the sum of the elasticity of demand for exports and the elasticity of demand for imports is greater
than one that devaluation will improve the balance of payments of a country devaluing its currency.
 Approaches to Balance of Payments
The J-Curve Effect:
Empirical evidence shows that the Marshall- Lerner condition is satisfied in the majority of advanced countries. But there is
a general consensus among economists that both demand-supply elasticities will be greater in the long run than in the short
run.
The effects of devaluation on domestic prices and demand for exports and imports will take time for consumers and
producers to adjust themselves to the new situation.

The short-run price elasticities of demand for exports and imports are lower and they do not satisfy the Marshall-Lerner
condition. Therefore, to begin with, devaluation makes the BOP worse in the short- run and then improves it in the long-
run. This traces a J-shaped curve through time. This is known as the J-curve effect of devaluation
 Approaches to Balance of Payments
The J-Curve Effect:
In the beginning, the curve has a big loop which shows increase in BOP
deficit beyond D. It is only after time T1 that it starts sloping upwards
and the deficit begins to reduce. At time T2 there is equilibrium in BOP
and then the surplus arises from T2 to J. If the Marshall-Lerner condition
is not satisfied, in the long run the J-curve will flatten out to F from T2.

However, in case the country is on a flexible exchange rate, BOP will get
worse when there is devaluation of its currency. Due to devaluation, there
is excess supply of currency in the foreign exchange market which may
go on depreciating the currency. Thus the foreign exchange market
becomes unstable and the exchange rate may overshoot its long-run
value.
 Approaches to Balance of Payments
Absorption Approach or Keynesian Approach
Based upon the Keynes General Theory of Employment, Interest and Money, Mrs. Joan Robinson, R.F. Harrod, Fritz
Machlup formulated Keynesian Approach to BOP Policy.
The absorption approach to balance of payments is general equilibrium in nature and is based on the Keynesian national
income relationships. It is, therefore, also known as the Keynesian approach. It runs through the income effect of
devaluation as against the price effect to the elasticity approach.
• It showed that any imbalance in BOP leads to an adjustment in income, employment and output irrespective of what
changes took place in prices and of how the deficit was financed.
• The interaction between BOP and National Income took place in two manner.
• Adjustment Process → BOP is adjusted by changes in the income levels of the home country and the rest of the world;
• Transmission Process → Shows how variations in NI of one country may through their balances of payments cause
variations in the national incomes of other countries
 Approaches to Balance of Payments
Absorption Approach or Keynesian Approach
The theory states that if a country has a deficit in its balance of payments, it means that people are ‘absorbing’ more than
they produce. Domestic expenditure on consumption and investment is greater than national income. If they have a surplus
in the balance of payments, they are absorbing less. Expenditure on consumption and investment is less than national
income. Here the BOP is defined as the difference between national income and domestic expenditure.
This approach was developed by Sidney S. Alexander, The effects of a Devaluation on the Trade Balance, 1952
 Approaches to Balance of Payments
Absorption Approach or Keynesian Approach
Y = C + Id + G + X-M … (1)
where Y is national income, C is consumption expenditure, total domestic investment, G is autonomous government
expenditure, X represents exports and M imports.
The sum of (C + Id + G) is the total absorption designated as A, and the balance of payments (X – M) is designated as B.
Thus Equation (1) becomes
Y=A+B
or B = Y-A …(2)
which means that BOP on current account is the difference between national income (Y) and total absorption (A). BOP
can be improved by either increasing domestic income or reducing the absorption. For this purpose, Alexander
advocates devaluation because it acts both ways. First, devaluation increases exports and reduces imports, thereby
increasing the national income.
 Approaches to Balance of Payments
Absorption Approach or Keynesian Approach
The additional income so generated will further increase income via the multiplier effect. This will lead to an increase in
domestic consumption. Thus the net effect of the increase in national income on the balance of payments is the
difference between the total increase in income and the induced increase in absorption, i.e.,

∆B = ∆ Y- ∆A … (3)

Total absorption (∆A) depends on the marginal propensity to absorb when there is devaluation. This is expressed as a.
Devaluation also directly affects absorption through the change in income which we write as D. Thus

∆A = a∆Y + ∆D … (4)

Substituting equation (4) in (3), we get

∆B = ∆Y-a ∆Y- ∆D

or ∆B = (1 – a) ∆Y- ∆D …(5)
 Approaches to Balance of Payments
Absorption Approach or Keynesian Approach
∆B = ∆Y-a ∆Y- ∆D

or ∆B = (1 – a) ∆Y- ∆D …(5)

The equation points toward three factors which explain the effects of devaluation on BOP. They are: (i) the marginal
propensity to absorb (a), (ii) change in income (∆Y), and (iii) change in direct absorption (∆D). It may be noted that
since a is the marginal propensity (MP) to absorb, (1 – a) is the propensity to hoard or save. These factors, in turn, are
influenced by the existence of unemployed or idle resources and fully employed resources in the devaluing country.
 Approaches to Balance of Payments
The Monetary Approach: It explains changes in balance of payments in terms of the demand for and supply
of money. According to this approach, a balance of payments deficit is always and everywhere a monetary
phenomenon. Therefore, it can only be corrected by monetary measures.
Assumptions:
1. The Law of one price’ [LOOP] holds for identical goods sold in different countries, after allowing
for transport costs.
2. Perfect substitution in consumption in both the product and capital markets which ensures one price
for each commodity and a single interest rate across countries.
3. Output level is assumed exogenously.
4. Full employment situation with wage price flexibility
5. Fixed exchange rates
6. Demand for money is a stock demand and is a stable function of income, prices, wealth and interest
rate.
7. Supply of money is a multiple of monetary base which includes domestic credit and the country’s
foreign exchange reserves.
8. Demand for nominal money balances is a positive function of nominal income.
 Approaches to Balance of Payments
The Monetary Approach: Given these assumptions, the monetary approach can be expressed in the form of the
following relationship between the demand for and supply of money: The demand for money (MD) is a stable function of
income (Y), prices (P) and rate of interest (i)

MD=f(Y, P ,i) (1)

The money supply (Ms) is a multiple of monetary base (m) which consists of domestic money (credit) (D) and country’s
foreign exchange reserves (R). Ignoring m for simplicity which is a constant,
Ms = D + R (2)
Since in equilibrium the demand for money equals the money supply,
Md = Ms (3)
or Md = D + R [MS = D + R] …(4)
A balance of payments deficit or surplus is represented by changes in the country’s foreign exchange reserves. Thus

∆R = ∆MD – ∆D … (5)
or ∆R = B …(6)
 Approaches to Balance of Payments
The Monetary Approach:
∆R = ∆MD – ∆D … (5)

or ∆R = B …(6)

where B represents balance of payments which is equal to the difference between change in the demand for money (∆Md)
and change in domestic credit (∆D).
⮚ A BoP deficit means a negative B which reduces R and the money supply.

⮚ A BoP surplus means a positive B which increases R and the money supply.

⮚ When BoP is balanced, B = 0, then BOP equilibrium.

The automatic adjustment mechanism in the monetary approaches is explained under both the fixed and flexible exchange
rate systems.
 Approaches to Balance of Payments
The Monetary Approach:

Under the fixed exchange rate system,

 Approaches to Balance of Payments
The Monetary Approach:

Under the fixed exchange rate system, assume that MD = Ms so that BOP (or B) is zero. Now suppose the monetary authority
increases domestic money supply, with no change in the demand for money. As a result, Ms > M0 and there is a BOP deficit.
People who have larger cash balances increase their purchases to buy more foreign goods and securities. This tends to raise their
prices and increase imports of goods and foreign assets. This leads to increase in expenditure on both current and capital
accounts in BOP, thereby creating a BOP deficit. To maintain a fixed exchange rate, the monetary authority will have to sell
foreign exchange reserves and buy domestic currency. Thus the outflow of foreign exchange reserves means a fall in R and in
domestic money supply. This process will continue until Ms = MD and there will again be BOP equilibrium.

On the other hand, if Ms < MD at the given exchange rate, there will be a BOP surplus. Consequently, people acquire the
domestic currency by selling goods and securities to foreigners. They will also seek to acquire additional money balances by
restricting their expenditure relatively to their income. The monetary authority on its part, will buy excess foreign currency in
exchange for domestic currency. There will be inflow of foreign exchange reserves and increase in domestic money supply. This
process will continue until Ms = MD and BOP equilibrium will again be restored. Thus a BOP deficit or surplus is a temporary
phenomenon and is self-correcting (or automatic) in the long-run.
 Approaches to Balance of Payments
The Monetary Approach:
Under a system of flexible (or floating) exchange rates,
 Approaches to Balance of Payments
The Monetary Approach:
Under a system of flexible (or floating) exchange rates, when B = O, there is no change in foreign exchange
reserves (R). But when there is a BOP deficit or surplus, changes in the demand for money and exchange rate
play a major role in the adjustment process without any inflow or outflow of foreign exchange reserves. Suppose
the monetary authority increases the money supply (Ms > MD) and there is a BOP deficit. People having
additional cash balances buy more goods thereby raising prices of domestic and imported goods. There is
depreciation of the domestic currency and a rise in the exchange rate. The rise in prices, in turn, increases the
demand for money thereby bringing the equality of MD and Ms without any outflow of foreign exchange
reserves. The opposite will happen when MD > Ms, there is fall in prices and appreciation of the domestic
currency which automatically eliminates the excess demand for money. The exchange rate falls until M0 =
Ms and BOP is in equilibrium without any inflow of foreign exchange reserves.
Questions
Questions