BALANCE OF PAYMENTS

MEANING AND COMPONENTS

MEANING OFBALANCE OF PAYMENTS

• The Balance of payments of a country is a systematic record of all its economic transactions with the outside world in a given year.

• According to Soderston, “the balance of payments is merely a way of listing receipts and payments in international transactions for a country.”

STRUCTURE OF BALANCE OF PAYMENTS ACCOUNTS

CREDITS(+) DEBITS (RECEIPTS) (PAYMENTS) 1. CURRENT ACCOUNT

EXPORTS IMPORTS(a) Goods (a) Goods(b) Services (b) Services(c) Transfer payments (c) Transfer payments 2. CAPITAL ACCOUNT

(a)Borrowing from foreign countries (a)Lending to foreign countries (b)Direct Investments by foreign countries (b)Direct Investments to foreign countries

3. OFFICIAL SETTLEMENTS ACCOUNTS

(a) Increase in Foreign Official Holdings (a) Increase in Official Reserve of Gold and o Foreign Currencies

4. ERRORS AND OMISSIONS

CURRENT ACCOUNTING

• The current account of a country consists of all transactions relating to trade in goods and services.

• Service transactions include costs of travel and transportation, insurance, income and payments of foreign investments.

• Transfer payments relate to gifts, foreign aid, pensions, private remittances, charitable donations etc., received from individuals and governments to foreigners.

CAPITAL ACCOUNTING

• The capital account of a country consists of its transactions in financial assets in the form of short term and long term lending and borrowings.

• Private and Official Direct Investments.• In other words, the capital account shows

international flow of loans and investments, and represents a change in the county’s foreign assets and liabilities.

THE OFFICIAL SETTLEMENTS ACCOUNT

• The official settlement account measures the change in nation’s liquidity and non liquid liabilities to foreign official holders and the change in a nation’s official reserve assets during the year.

• The official reserve assets of a country include its gold stock, holdings of its convertible foreign currencies and SDR’s, and its net position in the IMF.

ERRORS AND OMISSIONS

• Errors and omissions is a balancing item so that total credits and debits of the three accounts must equal in accordance with the principle of double entry book-keeping so that the balance of payments of a country always balances in the accounting sence.

IS BALANCE OF PAYMENTS ALWAYS IN EQUILIBRIUM?

• Balance of payments always balance means that the algebraic sum of the net credit and debit balances of current account, capital account and official settlement account must equal zero.

• Balance of payments is written as B= Rf – Pf where B=balance of payments Rf= receipts from foreigners Pf= payments made to foreigners• If B=Rf-Pf = 0,the balance of payments is in equilibrium.• If Rf-Pf>0, there is surplus in the balance of payments.• If Rf-Pf<0, there is deficit in the balance of payments.

MEASURING DEFICIT OR SURPLUS INBALANCE OF PAYMENTS

• If the total debits are more than total credits in the current and capital accounts, including errors and omissions, the net DEBIT BALANCE measures the DEFICIT.

• The deficit can be settled with an equal amount of NET CREDIT balance in the official settlements account.

• On the contrary, if the total credits are more than total debits in the current and capital accounts, including errors and omissions, the NET DEBIT balance measures the SURPLUS.

• The surplus can be settled with an equal amount of NET DEBIT balance in the official settlements account.

CAUSES OF DISEQUILIRIUM INBALANCE OF PAYMENTS

1. Temporary Disequilibrium(seasonal fluctuations)2. Fundamental Disequilibrium(consumer tastes, fall in foreign

exchange reserves, inflation, etc.,)3. Structural Disequilibrium(technological changes, import restrictions,

short supply of capital, etc.,)4. Changes in Exchange Rates(devaluation of currency)5. Cyclical Fluctuations(depression or boom)6. Changes in National Income(increase in GNP increases imports)7. Stage of economic development(LDC’s imports more)8. Capital movements(lending and borrowing)9. Political conditions(political instability discourage foreign investors

and hence outflow of capital)

MEASURES TO CORRECT DEFICIT INBALANCE OF PAYMENTS

1. Adjustments through Exchange Depreciation.2. Direct controls(limiting imports)3. Adjustment through Capital movements.4. Adjustment through Income changes.5. Stimulation of Export and Import Substitutes.

(Export promotion and Import Substitution)6. Expenditure Reducing policies.(reduction in

public expenditure and money supply reduce demand for import goods)