MODULE 8

BALANCE OF PAYMENTS, DEBT,

FINANCIAL CRISES AND
STABILIZATION POLICIES
 Financial crisis refers to
the period of extreme stress
in the financial and the
banking system.
 In a financial crisis, asset prices
see a steep decline in value,
businesses and consumers are
unable to pay their debts, and
financial institutions experience
liquidity shortages.
 A financial crisis happens
when financial instruments
and assets decrease its value
significantly
 Some examples of financial
instruments are cheques,
shares, stocks, bonds,
futures, and options
contracts.
 A cheque, or check is a
document that orders a bank (or
credit union) to pay a specific
amount of money from a person's
account to the person in whose
name the cheque has been issued.
 The person writing the cheque,
known as the drawer, has a
transaction banking account
(often called a current, cheque,
chequing, checking, or share
draft account) where the money
is held.
 The drawer writes various
details including the monetary
amount, date, and a payee on the
cheque, and signs it, ordering
their bank, known as the drawee,
to pay the amount of money
stated to the payee.
 A stock, also known as equity, is a
security that represents the ownership
of a fraction of the issuing corporation.
Units of stock are called "shares"
which entitles the owner to a
proportion of the corporation's assets
and profits equal to how much stock
they own.
 A bond is a fixed-income instrument
that represents a loan made by an
investor to a borrower (typically
corporate or governmental). A bond
could be thought of as an I.O.U.
between the lender and borrower that
includes the details of the loan and its
payments.
 IOU, a phonetic
acronym of the words "I
owe you," is a document
that acknowledges the
existence of a debt.
 Bonds are used by companies,
municipalities, states, and
sovereign governments to finance
projects and operations. Owners
of bonds are debtholders, or
creditors, of the issuer.
 Futures are derivative
financial contracts that
obligate parties to buy or sell
an asset at a predetermined
future date and price.
Options contract is an agreement
between two parties to facilitate a
potential transaction involving an asset
at a preset price and date. Call options
can be purchased as a leveraged bet on
the appreciation of an asset, while put
options are purchased to profit from
price declines.
 As a result, businesses have
trouble meeting their financial
obligations, and financial
institutions lack sufficient cash or
convertible assets to fund projects
and meet immediate needs.
Liquidity refers to the ease
with which an asset, or
security, can be converted
into ready cash without
affecting its market price.
 With financial crisis brought by COVID-
19 Pandemic, it is not just the banking
system and multinational and international
corporations that will be affected but the
consumers and even small borrowers as
well.
The
aftermath
of
pandemic
The aftermath of pandemic

How deep will the COVID-19

recession be? An investigation of 183
economies over the period 1870-
2021 offers a historical perspective
on global recessions
The aftermath of pandemic

Scenarios of possible growth

outcomes: Near-term growth
projections are subject to an unusual
degree of uncertainty; alternative
scenarios are examined.
The aftermath of pandemic

How does informality aggravate the

impact of the pandemic? The health
and economic consequences of the
pandemic are likely to be worse off in
countries with widespread informality.
The aftermath of pandemic

The outlook for low-income

countries: The pandemic is taking a
heavy human and economic toll on
the poorest countries
 The aftermath of pandemic

Regional macroeconomic implications:

Each region is faced with its own
vulnerabilities to the pandemic and
the associated downturn.
 The aftermath of pandemic

Impact on global value chains:

Disruptions to global value chains can
amplify the shocks of the pandemic
on trade, production, and financial
markets.
 The aftermath of pandemic

Lasting scars of the pandemic: Deep

recessions are likely to do long-term
damage to investment, erode human
capital through unemployment, and
catalyze a retreat from global trade and
supply linkages.
 The aftermath of pandemic

The implications of cheap oil: Low oil

prices that are the result of an
unprecedented drop in demand are
unlikely to buffer the effects of the
pandemic but may provide some support
during a recovery.
 Balance of Payments
The balance of payments (also known as balance
of international payments and abbreviated BOP or
BoP) of a country is the difference between all
money flowing into the country in a particular
period of time and the outflow of money to the
rest of the world.
 Balance of Payments
A specific record of a country’s and its
residents’ – individuals as well as business
organizations – monetary exchanges and
affairs with the rest of the world. It is
prepared quarterly as well as annually.
Ideally, it is supposed to be balanced or be
nil.
 Balance of Payments
That means the number of goods, services,
and money than any nation has sent out in the
world; the same amount should have been
received by it. This will make the Balance of
Payments nil.
 Balance of Payments
Almost all the countries in the world experience
imbalance in their Balance of Payments i.e. either
they are receiving more or giving more to the
world. Technically, this is known as ‘Deficit’ or
‘Surplus’ respectively.
 Balance of Payments
Structure of Balance of Payments
The Balance of Payment is generally divided into
two parts, also known as accounts.
1. Current Account
2. Capital Account
 Current Account

It accounts for the major portion of

Balance of Payments as it contains transactions
pertaining to the exchange of goods and services
entailing monetary transfers
 Current Account

These transactions include the

following:
•Export of goods and import of
goods in the economy
 Current Account

These transactions include the following:

•Export and import of services such as
consultancy services, outsourcing
contract payments, banking, insurance
etc.
 Current Account

These transactions include the

following:
•Unilateral transfers such as remittances
by workers who are abroad to their
families, gifts, donations etc.
 Current Account

These transactions include the following:

•Income on investments abroad as well as
payments made in connection with
foreign investments on native soil.
 Capital Account

It is comparatively a smaller part of Balance of

Payments. Any deficit or surplus in Balance of
Trade or Current Account above is transferred to
Capital Account.
 Capital Account

The following are the transactions that get

accounted for in Capital Account:
• Loans disbursed and received from abroad –
other countries as well as international
institutions in both public and private sector.
 Capital Account

The following are the transactions that get

accounted for in Capital Account:
• Investments made or liquidated in other countries
or made by non-residents in native
Country
 Capital Account

The following are the transactions that get

accounted for in Capital Account:
• Reserves of foreign currencies maintained by
central banks of respective countries
What does it mean to have a
surplus or a deficit in the
Balance of Payments?
 Ideally, a Balance of Payments should
always balance or tally. That means the debit
(receipt) and payment (credit) side should be
equal. But this scenario hardly materializes
with any country because there will always
be some amount of imbalance between
international receipts and payments due to a
country’s economic policies or fluctuations in
currency exchange rates.
 If the payments are more than the receipts,
that shows a ‘Deficit’ in the Balance of
Payments. It signifies that the country is
importing more goods and services than it is
exporting. This leads to an imbalance in the
Balance of Payments which is transferred to
the capital account.
 If the capital account is deficit, it is adjusted
either against the reserves of foreign currency
or by taking loans from abroad. These loans,
then, have to be used for creating and
developing infrastructural facilities that will
boost production in the country. Increased
production will lead to increased exports and
will bring in more revenues in foreign
exchange and the deficit can be nullified.
 If, on the other hand, a country fails to
utilize the foreign loans and
disbursements in order to strengthen its
economic growth, then it will continue to
rely on imports for satisfying its needs
which will lead to the ever-increasing
deficit in its Balance of Payments.
 Due to this, this country will, in
the end, be forced to liquidate some
of its assets such as mines, land and
other precious natural resources to
sustain its economy and repay the
foreign debts.
 Surplus, on the other hand, shows a
country’s prosperity. It shows that the
country is able to satisfy its needs
and is able to sell its products abroad
earning huge reserves of foreign
currency.
 However, to maintain parity in
international trade, the citizens of
this country will have to demand
more goods and services in order to
keep the monetary cycle flowing and
intact.
 Importance of Balance of Payments
It analyses the business transactions of any
economy into exports and imports of goods and
services for a particular financial year. Here, the
government can identify the areas that have the
potential for export-oriented growth and can
formulate policies supporting those domestic
industries.
 Importance of Balance of Payments
The government can adopt some protective
measures such as higher tariff and duties on
imports so as to discourage imports of non-
essential items and encourage the domestic
industries to be self-sufficient.
 Importance of Balance of Payments
If the economy needs support in the form of
imports, the government can formulate
appropriate policies to divert the funds and
technology imported to the critical sectors of the
economy that can drive future growth.
 Importance of Balance of Payments
If the country has a not so good export trade, the
government can adopt measures such as
devaluation of its currency to make its goods and
services available in the international market at
cheaper rates and bolster exports.
 Importance of Balance of Payments
The government can also use the indications from
Balance of Payments to discern the state of the
economy and formulate its policies of inflation
control, monetary and fiscal policies based on
that.
Debt
Crisis
 The COVID-19 pandemic has
greatly lengthened the list of
developing and emerging market
economies in debt distress. For
some, a crisis is imminent.
 Default rates are rising, and the
need for debt restructuring is
growing. Yet new challenges may
hamper debt workouts unless
governments and multilateral lenders
provide better tools to navigate a
wave of restructuring.
 The IMF, the World Bank, and
other multilaterals acted quickly to
provide much-needed funding amid
the pandemic as government
revenues collapsed alongside
economic activity, while private
capital flows came to a sudden stop.
 In addition to new loans from
multilaterals, Group of Twenty
(G20) creditors granted a debt
moratorium to the world’s poorest
countries. They have encouraged
private lenders to follow suit—
albeit with little success.
 The G20 or Group of Twenty is an
intergovernmental forum comprising 19
countries and the European Union. It
works to address major issues related to
the global economy, such as
international financial stability, climate
change mitigation, and sustainable
development
 The members of the G20 are:
Argentina, Australia, Brazil, Canada,
China, France, Germany, India,
Indonesia, Italy, Japan, Republic of
Korea, Mexico, Russia, Saudi Arabia,
South Africa, Turkey, the United
Kingdom, the United States, and the
European Union.
 A
moratorium is
a legal
authorization to
debtors to
postpone
payment
Accumulation
of Debt
and the
Emergence of
Debt Crisis
 Although foreign borrowing can be
highly beneficial, providing the resources
necessary to promote economic growth
and development, when poorly managed,
can be very costly.
 In recent years, these costs have
greatly outweighed the benefits for
many developing nations. The main cost
associated with the accumulation of a
large external debt is debt service.
 Debt Service is the
cash that is required
to cover the
repayment of
interest and
principal on a debt
for a particular
period.
 For example, if an
individual is taking out a
mortgage or a student
loan, the borrower needs
to calculate the annual or
monthly debt service
required on each loan.
Effects of
accumulated
debt
 Effects of
accumulated
debt

Increasing Debt
service
Effects of
accumulated debt

•Further
external
Borrowing
Effects of accumulated
debt

The country begins to

experience severe balance of
payment problems as
commodity prices fall or drop
straight down at high speed and
the terms of trade rapidly
deteriorate
Effects of accumulated debt

A global recession or some

other external shock, such as a
jump in oil prices, a steep rise in
interest rates on which variable-
rate private loans are based, or a
sudden change in the value of the
dollar, in which most debts are
denominated, takes place
Effects of
accumulated debt

A loss in confidence in the

ability of a developing
country to repay, causing
private international banks to
cut off their flow of new
lending
 Effects of accumulated debt

A substantial flight of capital is hastened by residents

who, for political or economic reasons (e.g., expectations
of currency devaluation), send great sums of money out of
the country to be invested in developed-country through
financial securities, real estate, and bank accounts.
Stabilization Policies
for Macroeconomic
Instability
Four Components of Stabilization Policies

Abolition or liberalization of
foreign-exchange and import
controls
Four Components of Stabilization Policies

Devaluation of the official

exchange rate
Four Components of Stabilization Policies

A stringent domestic anti-inflation

program
•control of bank credit to raise
interest rates and reserve
requirements;
Four Components of Stabilization Policies

A stringent domestic anti-inflation program

•control of the government deficit through
curbs on spending, including in the areas of
social services for the poor and staple food
subsidies, along with increases in taxes and
in public-enterprise prices;
Four Components of Stabilization Policies

A stringent domestic anti-inflation

program
•control of wage increases, in
particular abolishing wage
indexing; and
Four Components of Stabilization Policies

A stringent domestic anti-inflation

program
•dismantling of various forms of
price controls and promoting freer
markets
Four Components of Stabilization Policies

A stringent domestic anti-inflation

program
•dismantling of various forms of
price controls and promoting freer
markets
Four Components of Stabilization Policies

Greater hospitality to foreign investment and

a general opening of the economy to
international commerce bankers and
government officials of developed nations and
developing-country debtors were convened in
the financial capitals of the world.
 Tactics for Debt Relief
Debtor’s Cartel
A group of developing-country debtors who join to bargain
as a group with creditors. Following the onset of the debt
crisis, most developing countries were cut off from the
international capital market. Emergency meetings between
international bankers and government officials of developed
nations and developing-country debtors were convened in
the financial capitals of the world.
 Tactics for Debt Relief
Restructuring
Altering the terms and conditions of debt repayment, usually by
lowering interest rates or extending the repayment period. These
have ranged from a new allocation of special drawing rights to
restructuring (on better terms for debtor countries) of principal
payments falling due during an agreed consolidation period.
 Tactics for Debt Relief
Restructuring
These bilateral arrangements for public loans permit
creditor governments to choose from three alternative
concessional options— partial cancellation of up to
one-third of non-concessional loans, reduced interest
rates, or extended (25-year) maturity of payments—to
generate cash flow savings for debtor countries.
 Tactics for Debt Relief
Brady Plan
A program launched in 1989, designed to reduce
the size of outstanding developing-country’s
commercial debt through private debt forgiveness
procured in exchange for IMF and World Bank debt
guarantees and greater adherence to the terms of
conditionality
 Tactics for Debt Relief
Brady Plan
The Brady Plan, the principles of which were first
articulated by U.S. Treasury Secretary Nicholas F. Brady in
March 1989, was designed to address the so-called LDC
debt crisis of the 1980's. The debt crisis began in 1982,
when a number of countries, primarily in Latin America,
confronted by high interest rates and low commodities
prices, admitted their inability to service hundreds of
billions of dollars of their commercial bank loans.
 Tactics for Debt Relief
Brady Plan
Because many of these countries' economies were
then dependent on commercial bank financing,
continued debt rescheduling and the resulting
perception of uncreditworthiness led to a "lost
decade" of economic stagnation, during which
voluntary international credit and capital flows to
these nations and their private sectors were severely
interrupted.
 Tactics for Debt Relief
Debt-for-equity swap
A mechanism used by indebted developing
countries to reduce the real value of external debt by
exchanging equity in domestic companies (stocks) or
fixed-interest obligations of the government (bonds)
for private foreign debt at large discounts
 Tactics for Debt Relief

The exchange of foreign debt held

by an organization for a larger
quantity of domestic debt that is
used to finance the preservation of
a natural resource or environment
in the debtor country
MODULE 9
FISCAL POLICY FOR
DEVELOPMENT
 Fiscal policy
It refers to the use of government spending
and tax policies to influence economic
conditions, especially macroeconomic
conditions, including aggregate demand for
goods and services, employment, inflation,
and economic growth.
 Fiscal policy
It is largely based on the ideas of British economist
John Maynard Keynes (1883-1946), who argued that
economic recessions are due to a deficiency in the
consumer spending and business investment components
of aggregate demand. Keynes believed that governments
could stabilize the business cycle and regulate economic
output by adjusting spending and tax policies to make up
for the shortfalls of the private sector.
 Fiscal policy
It aims to move the economy to its potential output
level. Potential output is the economy’s maximum
sustainable output in the long run, given the supply
of resources, the state of technology, and the rules of
the game that nurture production and exchange. It
also referred to as the full employment output. When
the economy produces its potential output, it is
operating on its production possibilities frontier.
 Fiscal policy
If potential output is achieved, the economy
reaches full employment with no inflationary
pressure. At full employment, the economy is doing
well as possible in the long run. In theory, fiscal
policy can be used to ensure that the economy
achieves its potential, with full employment and
price stability.
 Fiscal policy
The unemployment rate that occurs when the
economy is producing its potential GDP is
called the natural rate of unemployment. At
this rate, there is no cyclical unemployment.
Generally accepted estimates of the natural rate
of unemployment are in the range of 5
to 6 percent of the labor force.
 Cyclical
unemployment

It is caused by economic downturns

or is related to changes in business
conditions that affect the demand for
workers. It is temporary, rising and
falling along with contractionary and
expansionary periods.
 Output Exceeding Potential
If the aggregate demand is equal to the
aggregate supply above the maximum output,
then output exceeds the economy’s potential.
Unemployment is below its natural rate. The
amount at which the actual output in the short
run exceeds the economy’s potential is called
expansionary gap.
 Expansionary Gap
An expansionary gap is an
economic term that refers to the
difference between the real Gross
Domestic Product (GDP) and the
potential GDP in a given economy.
 Output Exceeding Potential
Production beyond the economy’s potential
creates inflationary pressure in the economy.
Production exceeding the economy’s potential is not
sustainable in the long run. The result is higher
inflation and a return to the economy’s potential
output. To head off this higher inflation,
policymakers sometimes increase taxes or reduce
government spending to reduce aggregate demand.
 How is the Economy’s
Potential Output Measured?
Unlike actual GDP, we cannot observe
potential GDP and must estimate it. As
a result, different economists can have
different views of potential output. One
way to construct potential GDP is by
fitting a trend line through actual GDP.
 How is the Economy’s
Potential Output Measured?
For instance, starting in 2000 would lead to a trend
line that is defined by the expansion period and is
relatively steep. If, on the other hand, output rose
above potential during the expansion period, then the
trend line would be slightly flatter. The latter case
implies that output would have been above potential
during the boom period and perhaps not quite so far
below potential during the recession.
 How can Output Exceed the
Economy’s Potential
If you think of potential output as the economy’s normal
production capacity, you get a better idea of how the economy
can temporarily exceed that capacity. Consider your own study
habits. During most of the school year, you display your normal
capacity for academic work. As the end of the semester draws
near, you may step it up a notch to finish long-standing
assessment tasks. You may study more than usual and make an
extra effort trying to pull things together. During this brief
stretches, you study beyond your normal capacity, beyond the
schedule that you follow on a regular basis.
 How can Output Exceed the
Economy’s Potential
Producers, too, can exceed the normal capacity in the short run to
push output beyond the economy’s potential. Let’s take for
example, currently we are facing global economic crisis due to the
COVID-19 Pandemic, businesses pulled out their investments. The
unemployment rate rises at an unprecedented rate. However, in the
long run, the economy does not exceed its potential, just as you do
not boost your study effort permanently, such we shifted to online
learning. Output in the long run gravitates back to the economy’s
potential. Production beyond potential usually leads only to
inflation in the long run.
 Fiscal Policy and The
Economy
Fiscal policy is an important tool for
managing the economy because of its ability to
affect the total amount of output produced—
that is, gross domestic product. The first impact
of a fiscal expansion is to raise the demand for
goods and services. This greater demand
leads to increases in both output and prices.
 Fiscal Policy and The
Economy
Fiscal policy is based on the theories of British economist
John Maynard Keynes, which hold that increasing or
decreasing revenue (taxes) and expenditures (spending)
levels influence inflation, employment, and the flow of
money through the economic system. Fiscal policy is often
used in combination with monetary policy, which, in the
United States, is set by the Federal Reserve to influence
the direction of the economy and meet economic goals.
 Fiscal Policy and The
Economy
Fiscal policy is paramount to successful
economic management since taxes,
spending, inflation and employment all
factor into gross domestic product (GDP).
This figure details the value of goods and
services produced by a nation within a year.
 Fiscal Policy and The
Economy
To see how fiscal policy can affect the economy,
consider a fiscal expansion that leads to rising demand,
which, in turn, increases production. If this demand
increase occurs in a high employment economy, prices
will vary. However, in a low-employment economy, this
demand will lead to more employment and production
but not necessarily price variation. The change in GDP
depends on which of these situations applies.
 Fiscal Policy Indicators
The success of the economy is commonly measured
by a few factors including GDP. Another factor is
aggregate demand, which is the sum of goods and
services produced by a nation purchased at a certain
price point. The aggregate demand curve dictates that
at lower price levels, more goods and services are
demanded, while there is less demand at higher price
points.
 Fiscal Policy Indicators
Business tax policy
Taxes that businesses pay to the
government affects profits and the
amount of investment. Lowering taxes
increases aggregate demand and
business investment spending.
 Fiscal Policy Indicators
Government spending
Aggregate demand is increased by the
government's own spending.
 Fiscal Policy Indicators
Individual taxes
Taxes on individuals, such as income tax,
affects their personal
income and how much they can spend,
injecting more money back into the economy.
 Fiscal Policy Indicators
The two main tools of fiscal policy are taxes and spending.
Taxes influence the economy by determining how much
money the government has to spend in certain areas and how
much money individuals should spend. For example, if the
government is trying to spur spending among consumers, it
can decrease taxes. A cut in taxes provides families with
extra money, which the government hopes will, in turn, be
spent on goods and services, thus spurring the economy as a
whole.
 Fiscal Policy Indicators
Spending is used as a tool for fiscal policy to
drive government money to certain sectors
needing an economic boost. Whoever receives
those dollars will have extra money to spend –
and, as with taxes, the government hopes that
money will be spent on other goods and
services.
 Types of fiscal policy
Expansionary fiscal policy
Expansionary fiscal policy, designed to
stimulate the economy, is most often used
during a recession, times of high unemployment
or other low periods of the business cycle. It
entails the government spending more money,
lowering taxes or both.
 Types of fiscal policy
The goal of expansionary fiscal policy is to put
more money in the hands of consumers so they
spend more and stimulate the economy.
Explained in economic language, the goal of
expansionary fiscal policy is to bolster
aggregate demand in cases when private
demand has decreased.
 Types of fiscal policy
Contractionary fiscal policy
Contractionary fiscal policy is used to low economic
growth, such as when inflation is growing too rapidly.
The opposite of expansionary fiscal policy,
contractionary fiscal policy raises taxes and cuts
spending. As consumers pay more taxes, they have less
money to spend, and economic stimulation and growth
slow.
 Types of fiscal policy
Under contractionary fiscal policies, the
economy usually grows by no more than 3%
per year. Above this growth rate, negative
economic consequences such as inflation, asset
bubbles, increased unemployment and even
recessions may occur.
 How Fiscal Policy Affects Business
Investment opportunities
Businesses can see investment opportunities from
government spending as well as private investment.
This commonly happens during an expansionary policy,
when more money is flowing into the economy from the
government and from other sources since taxation is
also low. When a balance between price and demand are
met, then businesses can expect to thrive and grow
 How Fiscal Policy Affects Business
Slower growth
A contractionary financial policy may kick in to
prevent inflation when that balance is broken
and demand (and prices) fall. Businesses
typically rein in their growth due to rising taxes
and take measures to stay in the black with less
money flowing through the economy.
 How Fiscal Policy Affects Business
Taxation changes
Depending on their location, businesses face
several levels of taxation, including local, state
and federal. Businesses must contend with how
their state and local government taxes them and
how it interweaves with federal fiscal policy.
 How Fiscal Policy Affects Business
Unemployment rates
A major objective of fiscal policy is to minimize unemployment.
For example, the government can lower taxes to put more money
back in consumers' pockets. As such, people may be able to spend
more money, and companies may face increased demand. With
increased demand may come additional production tasks for
companies to complete, and businesses can respond by creating
more jobs and hiring more employees. As such, with proper fiscal
policy in place, a low unemployment rate may gradually increase.