11

BALANCE OF PAYMENTS

DEFINITION OF BALANCE OF PAYMENTS

Balance of payments (BOP) of a country is a systematic summary statement of a

country's international economic transactions during a given period of time, usually

a year. The study of balance of payments represents macroeconomic aspect of

international economics.

As cited in Lindert (2002) Kindleberger defines " The balance of payments of a

country is a systematic record of all economic transactions between residents of that

country and the rest of the world during a given period of time." 1

The International Monetary Fund defines the term Balance of Payments more

clearly and explicitly as follows - "the balance of payments is a statistical statement

that systematically summarises for a specific time period, the economic transactions

of an economy with the rest of the world. Transactions, for the most part between

residents and nonresidents, consists of those involving goods, services, and income;
 12

those involving financial claims on, and

liabilities to, the rest of the world; and those

(such as gifts) classified as transfers, which involve offsetting entries to balance - in

an accounting sense - one sided transaction." 2

In general, Balance of Payments (BOP) of a country is "a systematic record of all

economic transactions between the residents of the reporting country and the

residents of the rest of the world for a given period of time usually a year." Thus, it

comprises all types of transactions of a country like - exports and imports of goods

and services, purchase and sale of foreign assets, foreign direct investment and

portfolio investment as well as borrowing from and lending to the rest of the world.

Importance of Balance of Payments

A study of BOP is important because -

It serves as an indicator of the changing international economic or financial

position of a country.

It helps in formulation of a country's monetary, fiscal and trade policies.

It helps in determining the influence of foreign trade & transactions on the

level of national income of a country.

It is useful to banks, firms, financial institutions and individuals which are

directly or indirectly involved in international trade and finance.

It is an economic barometer of nation's progress vis--vis rest of the world.

BALANCE OF PAYMENTS ACCOUNTING

The BOP accounts of a country is constructed on the basis of an accounting

procedure known as double entry book - keeping. Double entry book keeping means

that each international transaction is recorded twice, once as a credit entry and once
 13

as a debit entry of equal amount. The reason for this is that in general every

transaction has two sides that is credit and debit.

When a payment is received from a foreign country, it is a credit transaction or

credit entry, while payment to a foreign country is a debit transaction or debit entry.

In a country's BOP , credit transactions or entries are entered with a positive sign

(+), and debit transactions or entries are entered with a negative sign (-).

In general, the credit transactions would include - exports of goods and services,

unilateral receipts such as gifts, grants etc .from foreigners, borrowings from

abroad, investments by foreigners in the country,(capital inflows) and official sale of

reserve assets including gold to foreign countries and international agencies. While,

the debit transactions would include - import of goods and services, unilateral

payments such as gifts, grants, etc. to foreigners, lending to foreign countries,

investments by residents in foreign countries, (capital outflows) and official

purchase of reserve assets or gold from foreign countries and international agencies.

These credit and debit transactions 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 settlements account or the

official reserves account.

STRUCTURE OF BALANCE OF PAYMENTS

The Balance of Payments of a country is mainly divided into two types of accounts -

(1) Current Account (2) Capital Account.

(1) Current Account - The current account of a country's balance of payments

consists of all transactions related to trade in goods, services, income and unilateral

transfers . The current account includes following items -

 14

(a) Merchandise Exports & Imports -

Merchandise exports and imports are the

most important items in the current account. In general, it covers a

significant portion of total transactions recorded in the BOP of a country.

Generally, exports are calculated on free on board (f.o.b.) basis which means

that the costs of transportation, insurance, etc. are excluded. Generally,

imports are calculated on carriage, insurance and freight (c.i.f.) basis which

means that costs of transportation, insurance and freight are included.

(b) Invisible Exports & Imports - Invisible exports & imports also known as

service exports & imports are another important component of current

account. Important invisible items would include - travel, insurance,

transportation, investment income in the form of profits, dividends, etc. and

Government not included elsewhere.(g.n.i.e)

(c) Unilateral Transfers - Unilateral transfers or transfer payments are the third

important component of current account. Unilateral transfers include gifts,

grants, etc. either received from abroad (credits) or given abroad. (debits).

They are one sided transactions, without a quid pro quo that has a

measurable value. The unilateral transfers could be official or private.

(2) Capital Account - The capital account of a country consists of its transactions

in financial assets in the form of short term and long term lending and borrowing

and private and official investments. In other words, the capital account shows

international flow of loans and investments, and represents a change in the country's

foreign assets and liabilities. The capital account mainly consists of -

a) Borrowing from & Lending to Foreign Countries - Borrowing from foreign

countries are credit entries because they are receipts from foreign countries.

Lending to foreign countries are debit entries because they are payments to
 15

foreign countries. This borrowing or

lending could be of short term i.e. up to

one year or long term i.e. more than one year. Borrowing from & lending to

foreign countries could be also called as net sale of assets to foreigners and

net purchases of assets from foreigners.

b) Direct Investment & Portfolio Investment - Direct investment is investment

in enterprises located in one country but effectively controlled by residents of

another country. As a rule, direct investment takes the form of investment in

branches and subsidiaries by parent companies located in another country.

Portfolio investment refers to purchases of foreign securities that do not carry

any claim on control or ownership of foreign enterprises. In brief, borrowing

from foreign countries and direct & portfolio investment by foreign countries

represent capital inflows. On the other hand, lending to foreign countries

and direct & portfolio investment in foreign countries represent capital

outflows.

In broader terms, real or income creating transactions are entered into current

account of BOP, while financial or capital transactions are entered into capital

account of BOP. Lindert (2002) remarks that " Balance -of -payments accounting is

unique in that it shows all the real and financial flows between a country and the rest

of the world." 3

(3)Other Components - Apart from the above two main accounts, BOP of a

country also includes some other entries like - (a) Transactions with IMF, (b) SDR

allocations, (c) Errors & Omissions and (d) Official settlements / Reserve account.

Table 3.1 shows broad structure of a balance of payments statement.

 16

Table 3.1 : Broad Structure of Balance of Payments

Sr. Particulars Credits Debits

No. (+) (-)

1 Current Account

(A)Exports (B)Imports

(a)Goods (a)Goods
(b)Services (b)Services

(C) Unilateral Transfer (C)Unilateral Transfer

receipts from abroad payments to abroad
(Gifts, grants, etc recd) (Gifts, grants, etc. given)
2 Capital
Account
(a)Borrowing from (a)Lending to Foreign
Foreign Countries / Net Countries / Net
sale of assets to purchases of assets
foreigners from foreigners
(b) Direct & Portfolio (b)Direct & Portfolio
Investment by Foreign Investment in Foreign
Countries Countries
3 Errors
&Omissio
ns

4
Overall Balance
5 of Payments
Official
Settlement /
Reserves
Account

BALANCES WITHIN THE BALANCE OF PAYMENTS STATEMENT

As the BOP statement is constructed on the basis of double entry book keeping, the

total credits will be always equal to total debits.a We can find out net balancesb for

different items in the balance of payment statement. However, from the policy

makers point of view some of the important balances are -

(1) Balance of Trade - There are two definitions with reference to the concept of

balance of trade or trade balance. (a) Narrow definition and (b) Broad definition.
(a) Narrow Definition - The narrow definition considers "Balance of trade as the

difference between the value of merchandise (or goods) exports and the value of

merchandise (or goods) imports." In this sense, it can be called as - Merchandise

balance or Goods balance.

Economists like James Meade and others do not accept this narrow definition and

consider it as wrong and insignificant from the point of view of national income of

the country. Moreover, this narrow definition was useful during mercantilist period

when services constituted an insignificant portion of the international trade. This

narrow definition is not useful today when services transactions have assumed

growing importance in international trade.

(b) Broad Definition - The broad definition of balance of trade is given by

economist James Meade and is accepted by most of the modern economists. In the

broader sense, "Balance of trade is the difference between the value of goods &

services exported and imported by a country."4 Balance of trade in this sense is also

known as Balance of Goods & Services.

In the familiar macro-economic equation,

Y=C+I+G+(X-M),

in which Y = National income, C = Consumption, I = Investment, G = Government

expenditure , X = Exports of Goods & Services, M = Imports of Goods & Services,

the expression X - M denotes balance of trade in Meade's terms. Balance of trade is

national income injection and for that reason it is better to use Meade's concept of

balance of trade. Equating balance of trade with goods balance alone is to ignore the

importance of service balance as a factor determining national income.

(2) Balance of Current Account - The concept of balance of current account or

current account balance is broader than the concept of balance of trade. It is said to
 be mirror image of capital account
including official reserves. The current account

balance includes the sum of three balances - merchandise balance, services balance

and unilateral transfers balance. In other words, it includes trade balance (in

Meade's terms) and transfers balance.

Balance of Current Account = Merchandise balance + Services Balance +

Unilateral transfers balance.

The current account reflects the value of the flow of goods, services, income and

gifts between the home country and the foreign countries. Current account balance

refers to the net of these flows. The balance of current account can be either surplus

or deficit. A current account surplus means an excess of exports over imports of

goods, services investment income and unilateral transfers. A current account deficit

means excess of imports over exports of goods, services, investment income and

unilateral transfers. In other words, if the sum of the exports of goods, services ,

investment income and unilateral transfers is greater than the sum of the imports of

goods, services, investment income and unilateral transfers, then there will be

current account surplus and vice - versa.

Importance of the Concept of Balance of Current Account - The balance of current

account is a very important concept, as it shows the flow aspect of a country's

international transactions. It represents bottom line of a nation's income statement. It

shows the change in reporting country's net foreign wealth. As pointed out by

Salvatore (2005) -"The current account lumps together all sales and purchases of

currently produced goods & services, and investment income, and unilateral

transfers and provides the link between the nation's international transactions and its

national income. Specifically, a current account surplus stimulates domestic

production, while a current account deficit dampens domestic production and

income."5

The concept of current account balance is linked with national income accounting

and its components in the following manner :

(a) Link with national saving and domestic investment - A country can do two

things with its national savings (S) : (i)Invest in home country (Id) or (ii) Invest in

foreign country (If). Hence, S = Id + If . Therefore, a country's net foreign

investment (current account balance - CAB) equals the difference between national

saving and domestic investment. i.e.

CAB = If = S - Id

Thus, the concept is synonymous with net foreign investment in national income

accounting.

(b) Link with domestic production, income and expenditure - A country's current

account balance is the difference between its domestic production of goods and

services and its total expenditure on goods and services.

A country's national output may be represented as -

Y = C + Id + G + X - M . (1)c

Where Y = National product / output , C = domestic consumption, Id = domestic

investment, G = Government expenditure, X = exports of goods & services, M =

imports of goods & services. C, Id and G all include purchases of both domestically

produced and imported goods & services. But, imports must be subtracted separately

because imports are not demand for the home country's products.

A country's total expenditure on goods and services i.e. C + Id + G is sometimes

referred to as absorption (A). It can be represented as -

A = C + Id + G (2)
 T
herefore, Y = A + ( X - M ) (3)

The above analysis implies that national product (Y) differs from national

expenditure or absorption (A= C + I d + G) by the amount of current account

balance, or the difference between exports and imports of goods and services

(including gifts), or X - M .

In a nutshell, the current account balance (CAB) in a balance of payment statement

implies - (a) the difference between exports of goods & services & imports of

goods & services (X - M), (b) Net foreign investment (I f), (c) The difference

between national savings and domestic investment (S - Id), and (d) The difference

between national product and national expenditure / absorption. (Y - A).

(3) Balance of Capital Account - Until recently, capital account was not a

significant component of balance of payments. This was because of severe

restrictions adopted by the countries on international capital movements. However,

in due course of time due to liberalization of trade, the countries have also eased or

removed their restrictions on international capital movements. Normally, the capital

account consists of all types of capital inflows and outflows. In general, it is

observed that the developing countries have surplus in their capital account, while

the developed countries have deficit in their capital account.

(4) Overall Balance of Payments - It is the sum of the balance of current account

and balance of capital account (including errors & omissions ). In some countries,

overall balance is also called as official settlement balance. The overall balance of

payments may either balance, or have a surplus, or have a deficit. In general it can

be said that (a) If the overall surplus in the BOP was caused by current account

surpluses but not capital account surpluses, then the surplus may be a good sign for

the country. (b) If the overall deficit in the BOP was caused by current account
 deficit rather than capital account deficits,
then the deficit may be considered as a

bad sign for the reporting country. Thus, not only the extent but location of overall

surplus or deficit is important. It is to be noted that different nations use different

measures of the overall balance of payments surplus or deficit. Some compare the

net increase in their official reserves with the net rise in a wide definition of liquid

foreign claims against the country. Others simply measure the change in official

reserves alone.

EQUILIBRIUM & DISEQUILIBRIUM IN BALANCE OF PAYMENTS

A country's balance of payments is said to be always 'balanced' in accounting sense

so there would be no 'imbalance' in a country's BOP. However, we come across the

term 'equilibrium' or 'disequilibrium' in relation to a country's BOP. This is

because the term 'balance'/ 'imbalance' is used in accounting sense while the term '

equilibrium' / 'disequilibrium' is used in economic sense. As Sodersten (1980)

remarks - "The problem of judging equilibrium position of a country's balance of

payments becomes fairly complicated and soon takes us outside the sphere of book -

keeping."6 Thus, while analyzing the equilibrium /disequilibrium in balance of

payments one has to consider the nature of international transactions in the BOP.

Autonomous & Accommodating Transactions

The nature of international transactions could be autonomous or accommodating.

(a) Autonomous Transactions - Autonomous transactions are those transactions

that take place regardless of the size of other items in the balance of

payments. They are also called as 'above the line transactions.' All the

transactions in the current and capital account are autonomous because they

are undertaken for business or profit motives and are independent of balance
 of payments situations. They are the
cause of BOP situation. For accounting

purposes it is reasonable to treat all the current and capital account

transactions as autonomous or above the line transactions. In brief, all the

credit and debit entries in the current and capital accounts are regarded as

'autonomous' transactions.

(b) Accommodating Transactions - Accommodating transactions are those

transactions which are undertaken deliberately to correct disequilibrium in

balance of payments. They are also called as 'below the line transactions'.

They are the result of balance of payments situation. The transactions in the

official reserve account are of accommodating nature undertaken by

monetary authorities to bring balances in the balance of payments. In brief,

all the credit and debit entries in the Official reserve account are regarded as

accommodating transactions.

Definition of Equilibrium / Disequilibrium in Balance of Payments

The distinction between autonomous and accommodating transactions is useful in

defining equilibrium / disequilibrium (surplus / deficit) in balance of payments.

(a) Equilibrium in BOP - A country's balance of payments is said to be in

equilibrium when its autonomous receipts (credits) are equal to its autonomous

payments (debits).

Equilibrium in BOP Autonomous Receipts = Autonomous Payments

(b) Disequilibrium in BOP - A country's balance of payments is said to be in

disequilibrium when its autonomous receipts (credits) are not equal to its

autonomous payments (debits).

Disequilibrium in BOP Autonomous Receipts Autonomous Payments

Disequilibrium in BOP could be in the form of surplus or deficit in the balance of

payments.

(1) Surplus in BOP - When the autonomous receipts (credits) are greater than

autonomous payments (debits), the balance of payments will be in surplus or

favourable. In other words, if total credits are more than total debits in the current

and capital account (including errors & omissions), the net credit balance measures

the surplus in the nation's balance of payments. This surplus is settled with an equal

amount of net debit in the official reserves account.

(2) Deficit in BOP - When the autonomous receipts (credits) are smaller than

autonomous payments (debits), the balance of payments will be in deficit or

unfavourable or adverse. In other words, if total debits are more than total credits in

the current and capital accounts (including errors & omissions), the net debit balance

measures the deficit in the nation's balance of payments. This deficit is settled with

an equal amount of net credit in the official reserve account.d

The analysis of equilibrium & disequilibrium in balance of payments is summarized

in table 3.2 .

Types of Disequilibrium

Disequilibrium in balance of payments can be classified as follows : -

(a) Temporary Disequilibrium - Temporary disequilibrium in the form of

deficits or surpluses tend to last for a short period of time. They are the result

of temporary changes in the economy like - crop failure, seasonal

fluctuations, effect of weather on agricultural production, etc. Such a

disequilibrium may occur once a while and gets automatically corrected. It

does not pose a serious problem for a country.

 (b) Fundamental Disequilibrium - There is no precise definition of the term

fundamental disequilibrium. Economists generally define fundamental

disequilibrium as - "a deep rooted persistent deficit or surplus in the BOP of

a country." It is a chronic BOP deficit, according to IMF. It is of long term

nature and a matter of serious concern for the country.

(c) Cyclical Disequilibrium - Cyclical fluctuations in the business activity also

lead to BOP disequilibrium. Cyclical disequilibrium occurs because - (i)

Trade cycles follow different paths and patterns in different countries. (ii)

Different countries follow different stabilization programmes. (iii)

Differences in price and income elasticities of demand for imports.

(d) Structural Disequilibrium - Structural disequilibrium occurs due to

structural changes in the economy. Some of the structural changes would

include - changes in technology, changes in tastes and preferences, changes

in long - term capital movements, etc.

Causes of Disequilibrium

The factors leading to disequilibrium (surplus or deficit) in balance of payments

could be broadly categorized into three -

(1) Economic factors - The important economic factors are (a) structural

changes in the economy, (b) changes in exchange rates (overvaluation /

undervaluation), (c) Changes in the level of foreign exchange reserves, (d)

Cyclical fluctuations, (e) Inflation / deflation (f) Developmental expenditure

undertaken by developing countries, etc.

(2) Social factors - The social factors may include changes in tastes &

preferences due to demonstration affect, population growth rate, rate of

urbanization, etc.
 (3) Political factors - The political factors
may include - political stability /

instability in a country, war, change in diplomatic policy, etc.

Table 3.2 : Equilibrium & Disequilibrium in Balance of Payments

Sr. Nature of transactions BOP Situation Official Changes in

No. Reserve Foreign
Account Exchange
Reserves
0 Autonomous Receipts = Equilibrium in Zero ( i.e. No change
1 Autonomous Payments Balance of No credit or
[ Total credits = Total Payments debit
debits in current & capital entry)
accounts (including errors
& omissions)]
Autonomous Receipts Disequilibrium Credit or Increase or

02
Autonomous Payments in Balance of Debit Decrease
Payments entry
0 Autonomous Receipts > Surplus in Net Debit Increase
2 Autonomous Payments Balance of entry
[ Total credits > Total Payments
A debits in the current and =
capital accounts(including Favourable
errors & omissions) BOP
02 Autonomous Receipts < Deficit in Net Decrease
B Autonomous Payments Balance of Credit
[ Total debits > Total Payments = entry
credits in the current & Unfavourable
capital accounts ( BOP , Adverse
including errors & BOP.
omissions)

Implications of Disequilibrium

A disequilibrium (surplus or deficit) in balance of payments is considered as

undesirable for a country. However, the implication of disequilibrium depends on

location or source and duration. In this context the following generalizations are

possible -
a) With respect to location it could be said that a surplus in the combined

current and capital accounts should be considered desirable for a country. On

the other hand, a deficit in the combined current and capital account should

be considered as undesirable for the country.

b) With respect to duration it could be said that if the disequilibrium (surplus /

deficit) is temporary or short term, then it is not much a serious concern for

the country. But, if the disequilibrium (surplus / deficit) is persistent or long

term, it is a matter of serious concern for the country and needs corrective

policy action.

c) A fundamental disequilibrium (in the form of deficit ) is undesirable because

- (i) Under a system of fixed exchange rates it forces the country to go for

devaluation , while under flexible exchange rates it causes depreciation in the

external value of the currency. (ii) It would lead to an increase in external

debt of the country and may lead to external debt trap. (iii) It leads to

depletion in foreign exchange reserves and again makes the position of

country extremely vulnerable. (iv) It makes the country totally dependent on

the loans supplied by international organizations and foreign governments

and raises serious doubt about the maintenance of its external sovereignty.

d) It is observed that disequilibrium in the form of surpluses are very rare while

disequilibrium in the form of deficits are a common phenomenon. Hence, in

practice, the term disequilibrium is normally associated with deficits in BOP.

MEASURES TO CORRECT DISEQUILIBRIUM IN BALANCE OF

PAYMENTS

The policy makers in different countries of the world always aim at achieving

equilibrium in the balance of payments over a period of time. As pointed out above

disequilibrium in the form of deficit is a matter of grave concern for the country.

Hence, if the country has a deficit in its BOP, then efforts are made by policy

makers to either remove or at least reduce the deficit and bring adjustment e in its

BOP.

The adjustment measures to correct disequilibriumf in BOP can broadly divided into

two types - (A) Automatic (B) Policy Induced or Deliberate .

(A) Automatic Adjustment - Under automatic adjustment , as the name implies,

the BOP adjustment comes about automatically, and it is not brought about

deliberately by government policy or intervention. The burden of adjustment is on

the economy and market forces and not on the government. It is argued that under

automatic adjustment if market forces of demand and supply are allowed to have a

free play, in course of time, BOP equilibrium will be automatically restored.

Assuming fixed or flexible exchange rates, the automatic adjustment in BOP takes

place through changes in prices, interest rates, income and capital flows. Thus, under

automatic adjustment there is no government intervention. However, it is to be noted

that automatic adjustment does not confirm to reality and has unwanted side effects.
g
(B) Policy Induced or Deliberate Measures - Under policy induced adjustment

there is government intervention in correcting disequilibrium in BOP. As the name

implies, deliberate measures are undertaken by the government to correct

disequilibrium in BOP. The government tries to correct disequilibrium through its

policy instruments like - monetary & fiscal policy, trade policy, devaluation,
 exchange controls etc. Thus, BOP
adjustment becomes a matter of policy. However,

the government policies designed to correct disequilibrium in BOP cannot neglect

the internal problems related to the economy like unemployment, inflation,

economic growth etc.

Policy Induced Measures

The most important objectives of a nation are : (a) internal balance, (b) external

balance (c) a reasonable rate of growth, (d) an equitable distribution of income and

(e) adequate protection of the environment, etc. In the present context, internal

balance and external balance are the two objectives or targets of government policy.

Internal balance refers to the achievement of full employment and price stability.

While external balance refers to the achievement of equilibrium in balance of

payments. Thus, internal balance is achieved by reducing inflation and

unemployment to zero and external balance is achieved by reducing BOP deficits

and surpluses to zero. Generally, government places priority on internal over

external balance, but they are sometimes forced to switch their priority when faced

with large and persistent external imbalances. The government through its various

policy instruments tries to achieve internal balance and external balance

To achieve the objectives of internal & external balance the main policy instruments

at the disposal of government are as follows -

1) Monetary & Fiscal Policy (Expenditure - Changing Policies) - Monetary and

fiscal policy are the two tools or instruments through which the twin objectives of

internal and external balance are achieved.h

Monetary policy affects the economy through changes in money supply and interest

rates. An expansionary monetary policy will increase the money supply and

decrease interest rates. While a contractionary monetary policy will decrease the
 money supply and increase interest rates. An
expansionary monetary policy will lead

to increase in the level of investment, output, income and imports. On the other

hand, a contractionary monetary policy will work in the opposite way.

Fiscal policy affects the economy through changes in government expenditure and

taxes. An expansionary fiscal policy means an increase in government expenditure

and /or decrease in taxes, while a contractionary fiscal policy means a decrease in

government expenditure and / or increase in taxes. An expansionary fiscal policy

will lead to increase in production, income and imports, while contractionary fiscal

policy will do the opposite.

It is to be noted that the effects of monetary policy on the BOP situation of a

country are highly predictable, whereas the effects of fiscal policy on the BOP are

less predictable. These policies seek to achieve internal & external balances by

altering the aggregate level of demand for goods and services, both domestic and

imported, by increasing or reducing the aggregate expenditure in the economy.

Hence, these two policies are also called as 'expenditure changing policies.'

Economists like Trevor Swan and others have identified four possible cases (zones)

of internal and external imbalance which calls for an appropriate mix of monetary

and fiscal policy. The four cases are - (1) Unemployment - BOP Surplus (2)

Inflation - BOP Surplus (3) Inflation - BOP deficit (4) Unemployment - BOP

Deficit. It is argued that an expansionary monetary & fiscal policy is suitable for

solving the problem of unemployment & BOP surplus. (Case 1). While, a

contractionary monetary & fiscal policy is suitable for solving the problem of

inflation and BOP deficit. (Case 3). But, the situation of inflation & BOP surplus

(Case 2) and unemployment & BOP deficit (Case 4) represent a policy dilemma.

This is because reducing inflation needs a contractionary policy while reducing BOP
 surplus needs an expansionary policy.
Similarly, reducing unemployment needs an

expansionary policy while reducing BOP deficit needs a contractionary policy.

Hence, both the cases need appropriate assignment of monetary & fiscal policies.

Trevor Swan (1955)7 argued that a country should achieve internal as well as

external balances simultaneously by using a flexible exchange rate policy and

monetary & fiscal policy package on the other. According to Swan, the role of

attaining external balance should be given to the flexible exchange rate system

(through currency devaluation / revaluation), while monetary & fiscal policy should

take care of internal balance. However, his solution is not accepted by economists

because when the economy follows monetary & fiscal policies simultaneously for

achieving internal balance (one target), it moves away from external balance (the

other target). (Case 2 & 4) .

Swan Diagram8 : Trevor Swan's analysis can be explained by Swan Diagram.

(Fig.3.1).

Fig. 3.1 : The Swan Diagram

66
In fig. 3.1 the vertical axis measures the exchange rate, and the horizontal axis

measures the real domestic expenditure or absorption. Points on the EE curve refer

to external balance, with points to the left indicating external surplus and points to

the right indicating external deficit. Points on the YY curve refer to internal balance,

with points to the left indicating internal unemployment and points to the right

indicating internal inflation. The crossing of EE and YY curves defines the four

zones of external and internal imbalance and helps us to determine the appropriate

policy mix to reach external and internal balance simultaneously at point F. If the

economy is not at point F, then it is in disequilibrium, i.e. it is in one of the four

zones. When the economy follows expenditure changing monetary and fiscal

policies simultaneously in zones II & IV, to achieve internal balance (one target) it

moves away from external balance (the other target).

Mundell's Assignment Rule : Mundell has given solution to the solve the dilemma

with the help of assignment. The assignment problem involves the pairing of a

particular policy instrument with a particular target. According to the principle of

effective market classification developed by Mundell the policy assignment is stable

when each policy instrument is assigned to that target on which it has relatively the

most influence. Robert Mundell's (1962)9 assignment rule provides a useful

guideline for assigning policy tasks to monetary and fiscal policies. According to

him, under fixed exchange rates, assigning monetary policy for external balance and

fiscal policy for internal balance would be an "appropriate" assignment. Thus, for

solving Unemployment - BOP deficit case, the country should adopt expansionary

fiscal policy and contractionary monetary policy. While for solving Inflation - BOP
 surplus case, the country should adopt
contractionary fiscal policy and expansionary

monetary policy. Hence, Mundell's assignment rule calls for a judicious mix of

monetary & fiscal policy. Mundell's analysis can be summarized in table 3.3 .

Table 3.3 : Monetary - Fiscal Policy Mix for Internal & External Balance

State of State of the Domestic economy

Balance of
Payments
High Unemployment Rapid Inflation
Surplus A C
Expansionary Monetary & Contractionary Fiscal Policy
Fiscal Policies & Expansionary Monetary
Policy
Deficit B D
Expansionary Fiscal Policy & Contractionary Monetary &
Contractionary Monetary Fiscal Policies
Policy

2) Devaluation (Expenditure Switching Policy) - Devaluation means reduction in

the external value of the country's currency undertaken by the government

officially. It is a deliberate action taken by the government deliberately and legally.

Devaluation does not change internal purchasing power of a currency. A country

devalues its currency in order to correct its BOP deficit. Devaluation is considered

as 'expenditure switching policy' because it switches expenditure from imported

goods to domestic goods & services. Thus, when a country with BOP deficit

devalues its currency, the domestic price of its imports increases and the foreign

price of its exports falls. This makes exports cheaper and imports costlier. Now the

foreigners can buy more goods by paying less money than before devaluation. This

encourages exports. This causes expenditure to be switched from foreign to

domestic goods as the country's exports increase and the country produces more to

meet the domestic and foreign demand for goods. On the other hand, with imports
 becoming costlier than before, they decline.
Thus, with the rise and exports and fall

in imports, BOP deficit is corrected. It is to be noted that the IMF considers

devaluation as a means to correct fundamental disequilibrium in a country's BOP

but it is to be used only as a last resort.

Effects of Devaluation - Theoretically it is said that devaluation would - (a)

encourage exports and discourage imports of goods and services and thereby

improve trade balance and current account balance. (b) It would encourage capital

inflows and improve capital account balance. The two tendencies together would

improve the overall BOP situation of the country. (c) The effect of devaluation on

terms of trade depends on demand and supply elasticities for exports and imports.

(d) The effect of devaluation on national income depends on whether devaluation

improves or worsens terms of trade. If the terms of trade improve, national income

will rise and vice versa.

Conditions for the success of Devaluation - The success of devaluation depends

on some essential conditions which are as follows -

The demand for exports & imports should be fairly elastic. In other words, it

should satisfy Marshall - Lerner condition.

The supply of exports should be adequate to meet the increased demand for

exports after devaluation.

There should be domestic price stability after devaluation.

Devaluation will be successful only if other countries do not devalue their

currencies simultaneously. In other words, there should not be retaliation.

 There should be international cooperation. In other words, the other countries

should not adopt measures to counter the effects of devaluation. Such

measures would include - increase in tariff duties, export subsidies, etc.

Devaluation cannot be successful in isolation, so it should be supported by

monetary, fiscal and other trade policy measures.

There are also two issues which are associated with the effects of devaluation.

They are (a) J - Curve effect and (b) Currency - Pass through relationship.

(a)J - Curve Effect - It is generally argued that devaluation will initially deteriorate

trade balance, and later on improve trade balance. In other words, following a

devaluation or depreciation of the domestic currency, the balance of trade typically

worsens for several months before it eventually improves. This phenomenon is

known as J- curve, because the trade balance traces a J -shaped curve through time.

Thus, J - curve effect shows the time path of the response of trade flows to
devaluation. Fig. 3.2 shows a typical J - curve.10

Fig. 3.2 :- A Typical "J - Curve"

In fig.3.2, trade balance is measured on vertical axis, and time is measured on

horizontal axis. Assuming that the original trade balance is zero, a devaluation or

depreciation of the nation's currency will first result in deterioration of the nation's

trade balance before showing a net improvement after time A.

(b) Currency - Pass through Relationship - The effect of devaluation also

depends on currency - pass through relationship. The extent to which changing

currency values lead to changes in import and export prices is known as currency -

pass through relationship. It is theoretically assumed that a given change in the

exchange rate brings about a proportionate change in import prices. In practice,

however, this relationship may be less than proportionate, thus weakening the

influence of a change in the exchange rate on the volume of trade.

Empirical evidence suggests that in reality there is partial pass -through, with

significant time lags. For example, for United States, it is estimated that for every

10 percent change in the value of the dollar, both import prices and export prices

change about 6 per cent.

3) Exchange Control - Exchange control also forms a part of expenditure -

switching policy because they too aim at switching of expenditure from imported

goods and services to domestic goods and services. Exchange control serves the

dual purpose of restricting imports and regulating foreign exchange.

Under the exchange control, the whole foreign exchange resources of the nation,

including those currently occurring to it, are usually brought directly under the

control of the exchange control authority. The exchange control authority is usually
the government or central bank of the country. Dealings and transactions are

regulated by the exchange control authority.

The recipients of foreign exchange like exporters are required to surrender foreign

exchange to the exchange control authority in exchange for domestic currency. The

exchange control authority allocates the foreign exchange on the basis of national

priorities.

Exchange control methods could be direct and indirect. Direct methods would

include - intervention and regulation in matters concerning exchange rates, foreign

exchange restrictions, multiple exchange rate policies, exchange clearing

agreements, etc. Indirect methods would include - import tariffs & quotas, export

subsidies, etc.

4) Trade Policy Measures - Trade policy measures would include measures which

would reduce imports and promote exports. The important trade policy measures are

- (a) Import controls (b) Export promotion.

(a) Import controls - A country may control its imports by imposing or

increasing import duties, restricting imports through import quotas, licensing,

prohibiting altogether the import of certain non essential items, etc.

(b) Export promotion - A country would promote exports by reducing or

abolishing export duties, providing export subsidies, encouraging production of

exportables, provide monetary, fiscal, physical and institutional incentives and

facilities to exporters, etc.

To sum up, there are four policy induced measures to correct disequilibrium in

balance of payments. They are (1) Monetary & fiscal policy, (2) Devaluation, (3)

Exchange control and (4) Trade policy measures. However, in practice none of
 these measures are used in isolation. On
the contrary, majority of them are used

together and hence can be said to be complimentary to each other.

CONCLUSION

Balance of Payments is said to be a systematic record of all international economic

transactions during a given period of time, usually a year. The study of balance of

payments represents macroeconomic aspect of international economics. As it is

based on double entry book - keeping, balance of payments always balances in the

accounting sense of the term. The current account and capital account are the two

main components of the balance of payments statement. From an economist point

of view, within the balance of payments statement - trade balance, current account

balance, capital account balance and overall balance are important.

The distinction between autonomous and accommodating transactions is useful in

defining equilibrium / disequilibrium (surplus / deficit) in balance of payments.

Equilibrium in BOP would mean that its autonomous receipts are equal to

autonomous payments. While disequilibrium in BOP means that its autonomous

receipts are not equal to autonomous payments. When autonomous receipts are

greater than autonomous payments there is surplus in BOP, and when autonomous

receipts are less than autonomous payments there is a deficit in BOP.

Disequilibrium in the BOP can be in the form of temporary, fundamental, cyclical

and structural. Disequilibrium in BOP is caused by economic, social and political

factors. Disequilibrium in the form of deficit is a matter of grave concern for the

country. Hence, if the country has a deficit in its BOP, then efforts are made by

policy makers to either remove or at least reduce the deficit.

The measures to correct disequilibrium can be automatic or policy induced.

However, in reality most of the countries adopt policy induced measures to correct
 disequilibrium in BOP. Some of the policy
induced measures are - (a) Monetary -

Fiscal policy mix, (b) Devaluation, (c) Exchange control and (d) Trade policy

measures.

Monetary policy affects the economy through changes in money supply and interest

rates. While Fiscal policy affects the economy through changes in government

expenditure and taxes. According to Mundell, monetary policy should be used to

achieve internal balance, while fiscal policy should be used to achieve external

balance.

Devaluation means reduction in the external value of the country's currency

undertaken by the government officially. It is a deliberate action taken by the

government deliberately and legally. Theoretically it is said that devaluation would

encourage exports and discourage imports of goods and services and thereby

improve trade balance and current account balance. However, the success of

devaluation depends on several factors like - achievement of Marshall - Lerner

condition, no retaliation by other countries and the use of appropriate monetary,

fiscal and trade policies. Exchange control serves the dual purpose of restricting

imports and regulating foreign exchange. Under exchange control, the foreign

exchange resources of the country are usually brought directly under the control of

the exchange control authority. Finally, trade policy measures would include import

controls and export promotion. Some of the important import control measures are -

import duties and quotas. Some of the export promotion measures would include -

providing export subsidies, encouraging production of exportables, providing

incentives and facilities to exporters, etc. It is pertinent to note that most of the

policy induced measures are used together and hence they are complimentary to

each other.