balance-of-payments-disequilibrium.docx

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urplus disequilibrium is termed as 'favourable balance'.

Causes of Disequilibrium in Balance of Payment ↓

1. Population Growth

Most countries experience an increase in the population and in some likeIndia and China the population is not only

large but increases at a faster rate. To meet their needs, imports become essential and the quantity of imports may

increase as population increases.

2. Development Programmes

eveloping countries !hich have embarked upon planned development programmes require to import capital goods,

some ra! materials !hich are not available at home and highly skilled and speciali"ed manpo!er. #ince

development is a continuous process, imports of these items continue for the long time landing these countries in a

balance of payment deficit.

. Demonstration !ffect

$hen the people in the less developed countries imitate the consumption pattern of the people in the developed

countries, their import !ill increase. Their export may remain constant or decline causing disequilibrium in the

balance of payments.



". #atural $actors

%atural calamities such as the failure of rains or the coming floods may easily cause disequilibrium in the balance of

payments by adversely affecting agriculture and industrial production in the country. The exports may decline !hile

the imports may go up causing a discrepancy in the country's balance of payments.

%. Cyclical $luctuations

&usiness fluctuations introduced by the operations of the trade cycles may also cause disequilibrium in the country's

balance of payments. or example, if there occurs a business recession in foreign countries, it may easily cause a fall

in the exports and exchange earning of the country concerned, resulting in a disequilibrium in the balance of

payments.

&. 'nflation

(n increase in income and price level o!ing to rapid economic developmentin developing countries, !ill increase

imports and reduce exports causing a deficit in balance of payments.

(. Poor )ar*eting +trategies

The superior marketing of the developed countries have increased their surplus. The poor marketing facilities of the

developing countries have pushed them into huge deficits.



,. $light -f Capital

ue to speculative reasons, countries may lose foreign exchange or gold stocks )eople in developing countries may

also shift their capital to developed countries to safeguard against political uncertainties. These capital movements

adversely affect the balance of payments position.

. Globalisation

ue to globalisation there has been more liberal and open atmosphere for international movement of goods, services

and capital. Competition has beer increased due to the globalisation of international economic relations. The

emerging ne! global economic order has brought in certain problems for some countries !hich have resulted in the

balance of payments disequilibrium.

BOP Disequilibrium

:

BOP Disequilibrium BOP statements are prepared on the principles of accounting

There is often a surplus or deficit in BOP This is called Disequilibrium in BOP

:



Autonomous and Induced Transactions Autonomous transactions are carried out on

their own with a view to consume more or make profit They take place on both

current and capital accounts nrequited items like gifts! donation and aid are

autonomous transactions

Induced Transactions :

Induced Transactions Balancing transactions are in form of international borrowing

and lending They are made for making payments for deficits in Balance of Trade

Assessment of BOP :

Assessment of BOP Autonomous transactions only are taken into account BOP

disequilibrium is of either surplus nature or deficit nature "urrent account deficit # $et capital inflow "urrent account deficit is the result of autonomous transaction $et

capital inflow is induced transaction

Capital account transactions :

"apital account transactions Autonomous transactions Official transactions The

decrease in official foreign e%change reserves gives the measure of BOP deficit BOP

deficit # decrease in official foreign e%change reserves # current account deficit & net

capital inflow

Causes and Kinds of BOP :

"auses and 'inds of BOP Inflation and (undamental Disequilibrium Business cycle

and "yclic Disequilibrium )tructural "hanges and )tructural Disequilibrium )hort*

term Disequilibrium )easonal deficits caused by crop failure +apid growth of

population in food*deficient countries Ambitious development plans Demonstration

effect of advanced countries on developing nations

:

Automatic Ad,ustment in BOP BOP Ad,ustment can be done in two ways "lassical

Approach Policy -easures



:

BOP Ad,ustment nder (i%ed .%change +ate / 0/ 01 02 Income 0 Interest +ate i3

i2 i/ ( . 4 5-/ 5-1 5-2 BOP I)/ i678

:

BOP Disequilibrium6)urplus8 and Automatic Ad,ustment nder (le%ible .%change

+ate / 01 02 Income 0 Interest +ate i2 i1 ( . 5- I)2 BOP2 BOP1 i678 I)1

:

BOP Disequilibrium6Deficit8 and Automatic Ad,ustment nder (le%ible .%change

+ate / 01 02 Income 0 Interest +ate i2 i1 ( . I)1 BOP1 BOP2 i678 I)2 5- BOPDeficit

:

BOP ad,ustment by policy measures

:

BOP ad,ustment by policy measures -undell *(leming -odel 9hy -undell :(leming model; +equired market condition do not e%ist .conomic cost is very high

)urplus countries unwilling to allow ad,ustment

:

9hat are policy measures< .%penditure changing policies; * -onetary policy * (iscal

policy .%penditure switching policy; * Devaluation * +evaluation -onetary approach

:

Trade Deficit 6" & I & 48 : 0 " & I & 4 -onetary Policy (iscal Policy Assumption

fi%ed .%change +ate .%penditure "hanging Policies



:

BOP Ad,ustment through -onetary Policy

:

BOP Ad,ustment through (iscal Policy 0/ 01 02 Income 608 Interest +ate 6r8 5- r1

r2 r3 I)3 I)2 I)1 ' = .3 .B .B> .1 .2

:

BOP Ad,ustment through -i% Policy

:

Assignment Dilemmas in Policy -i%

:

-undellian policy Assingment

:

Parameters are unknown and difficult to determine Determination of e%act

combination is difficult Prediction may differ due to non*economic factors "apital

flow is accommodating not autonomous "onflict between nations Problems in

-undellian policy Assignment

:

.%change Depreciation .%change Appreciation .%penditure )witching Policy

:

Pre*Devaluation Bc 1 # Ac ? A>s Import # 3?/ 608 % Bc 3/ # Bc 1/!?// A>s .%port #

1// 6@8 % Bc / # Bc !/// Trade deficit # Bc !?// .%penditure )witching Policy



:

Post*Devaluation Bc 1 # Ac C A>s Import # 3// 608 % Bc 2? # Bc C!?// A>s .%port #

1?/ 6@8 % Bc ? # Bc !C?/ Trade deficit # Bc C?/ .%penditure )witching Policy

:

Devaluation and Internal and .%ternal Balance

:

-arshall : 5erner "ondition; BOP deficit only if demand is elastic BOP deficit if

demand is perfectly inelastic $o effect if sum of price*elasticity equals .ffectiveness

of Devaluation

:

.mpirical .vidence and =*curve effect

:

-onetary Approach to BOP

:

-onetary Approach to BOP It was developed by +obert -undell in 1E and 1C1

and Farry =ohnson in 1C2G According to the modern monetary approach BOP

disequilibrium is a monetary phenomenonG

:

-onetary Approach to BOP Demand and the supply of money is transitory

phenomenon and is self correcting in the long runG BOP surplus results when there is

e%cess of demand of money over the supply of money and vice versaG HBOP bottoms

upG



:

The )elf "orrecting mechanism / 1// 2// 3// // ?// // 2/ / / E/ -s m 6DB8

-d . ' = 5 - )urplus Deficit International +eserves 6bn +sG8

India’s BOP 2006 - 09 :

India>s BOP 2// * /

India’s BOP 2006 - 09 :

India>s BOP 2// * /

:

:

TFA$' 0O

Types of isequilibrium in Country's &alance of )ayment

&alance of )ayment of the country is determined by a multiplicity of forces and the equilibrium in it is the resultant of

numerous inter*related elements.

http://kalyan-city.blogspot.com/2010/12/types-of-disequilibrium-in-countrys.html

http://kalyan-city.blogspot.com/2010/12/types-of-disequilibrium-in-countrys.html



The main types of disequilibrium in the balance of payment are as follo!s +*

1. +tructural Disequilibrium

It takes place due to structural changes in the economy affecting demand and supply relations in commodity and

factor market. #tructural disequilibrium in balance of payments persists for relatively longer periods as it is not easy

to remove structural imbalance in the economy.

#ome of the important causes of structural disequilibrium are as follo!s +*

-. If the foreign demand for a country's products decline due to the discovery of cheaper substitutes abroad,

then the country's export !ill decline causing a deficit.

. If the supply position of a country is affected due factors like crop failure, shortage of ra!*materials, strikes,

political instability, etc, then there !ould be the deficit in the balance of payments.

/. ( shift in demand due to the changes in tastes, fashions, income, etc, !ould increase or decrease the

demand for imported goods causing a disequilibrium in the balance of payments.

0. Changes in the rate of international capital movements may also cause structural disequilibrium.

1. ( !ar also results in structural changes !hich may affect not only goods but also factor of production

causing a disequilibrium in balance of payments.



2. Cyclical Disequilibrium

$hen disequilibrium is caused due to the changes in trade cycles, it is termed as cyclical disequilibrium. It is possible

that different phases of trade cycles like depression, prosperity, boom, recession, etc, may disturb terms of trade and

cause disequilibrium in balance of payments.

or instance, during boom period, imports may increase considerably due to increase in demand for imported goods.

uring recession and depression, imports may be reduced due to fall in demand on account of reduced income.

uring recession exports may increase due to fall in price. uring boom period, a country may face deficit in its &o)

position on account increase in imports. 2o!ever, during recession its export may increase, and as such &o)

position may sho! surplus.

(lso, the importing countries may face cyclical changes. or instance, there may be recession in the importing

countries, !hich in turn !ould reduce demand for imports. Therefore, the demand for exports !ill decline and the

exporting country may face a trade deficit, !hich in turn may affect &o) positions.

. /echnological Disequilibrium

Technological disequilibrium in balance of payments is caused by various technological changes involve inventions or

innovations of ne! goods or ne! technique of production. These technological changes affect the demand for factors

and goods.

( technological change !ill give comparative advantage to the innovating country leading to the increase in exports

or a decline in imports. This !ill create disequilibrium in the balance of payments.

". +hort run Disequilibrium

isequilibrium caused on a temporary basis for a short period, say one year is called short run disequilibrium. #uch

disequilibrium does not pose a serious threat as it can be overcome !ithin a short run. #uch an disequilibrium may be



caused due to international borro!ing and lending. $hen a country goes for borro!ing or lending it leads to short run

disequilibrium. #uch disequilibrium is 3ustified as they do not pose a serious threat.

#hort run disequilibrium may also be caused !hen a country's imports exceeds exports in a particular year. #uch

disequilibrium is not 3ustified as it has the potentiality to develop in to a crisis in time. The crisis in India in -445*4- is

nothing but the development of short run disequilibrium. If the short run disequilibrium is persistant 6 occurs

repeatedly it may pave the !ay for long run disequilibrium.

%. 0ong run or +ecular Disequilibrium

It prevails for a long period of time i.e. !hen the disequilibrium is persistent 6 long run oriented, it is called long run

disequilibrium The IM terms such disequilibrium as 7undamental isequilibrium7.

8ong*run or fundamental disequilibrium refers to a persistent deficit or a surplus in the balance of payments of a

country. It is also kno!n as secular disequilibrium.

$hen there is a continuous increase in the stock of gold and foreign exchange reserves. there is a persistent surplus

6 vise*versa.

)ermanent changes in the conditions of demand and supply of exports and imports cause fundamental

disequilibrium. ( permanent deficit or surplus may make a country debtor or creditor causing a fundamental

disequilibrium.

( developing country in its initial stages may import large amount of capital 6 hence its imports !ould exceeds

exports. $hen this becomes chronic, there emerges a secular deficit in its balance of payments. eep rooted

dynamic changes like capital formation, innovations. technological advancements, gro!th of population etc. also

contribute to fundamental disequilibrium.

$hen there is a series of short*run disequilibrium in a country's balance of payments, ultimately it !ould lead to

fundamental disequilibrium.

&. )onetary Disequilibrium



Monetary disequilibrium, takes place on account of inflation or deflation. ue to inflation. the prices of the products in

the domestic market rises, and therefore, export items !ill become expensive. #uch a situation may affect the &o)

equilibrium. Inflation also results in to increase in money income !ith the people, !hich in turn may increase demand

for imported goods. (s a result imports may turn &op position in disequilibrium.

!plain how B-P isequilibrium is restore uner

a. flexible exchange rates.

b. fixed exchange rates, after you define !hat a &9) disequilibrium means.

a+

:sing trade barriers such as tariffs, quotas and custom duties or monetary tools such as exchange rate

depreciation;appreciation, devaluation;evaluation, deflation;inflation.

b+

9nly using trade barriers such as tariffs, quotas and custom duties, because monetary policy in this case

is 3ust reactive tool to maintain exchange rate <though formally it is possible to use monetary equilibrating

correction methods, but price level spread may arise, making bank to pay high costs for maintaining fixed

exch*rate=.

&o) * balance of payments.

&o) * disequilibrium means that open economy has continuing severe unemployment;over*employment

<output;>) etc.=

There are fe! sources of &o) disequilibrium's, external and internal.

Though some specific tools depend on model you are referring to * you haven't specified it, for instance

?eynesian models <I#*8M or Mundel*lemming= may suggest some fiscal tools depending on si"e of

economy.

The &alance of )ayments <&o)=

( system of accounts that measures transactions of goods, services, income and

financial assets bet!een domestic residents, businesses and governments and

the rest of the !orld during a specific time period.

Current (ccount <C(= measures the flo! of goods, services, investment income

and transfers ; gifts bet!een domestic residents, businesses and governments

and the rest of the !orld.



)rivate Capital;inancial (ccount <)(= @ ( tabulation of the flo!s of

financial assets bet!een domestic private residents and foreign private

residents.

9fficial #ettlements &alance <9#&= @ tabulates transactions of reserve assets

<gold, #As, foreign currency holdings and reserve position in the IM= by

official government agencies. :sed for intervention in the 9AB market to

influence the BA.

&alance of payments accounts

- Bxports of goods and services <D=

E Merchandise, #ervices <travel, insurance, banking etc=.

E Income from assets held abroad+ interest, dividends etc.

Imports of goods and services <*=

E Merchandise, #ervices <travel, insurance, banking etc=.

E oreign investors' income from assets in the reporting country+ interest,

dividends etc.

/ :nilateral transfers <<*= F net outflo!=

0 Current account <F- D D /=

1 )rivate assets abroad, net <increase F capital outflo! <*==

E irect investment, )ortfolio investment.

G )rivate foreign assets in reporting country, net <increase F capital inflo! <D==

E irect investment, )ortfolio investment

H Capital account <1 D G=

Change in foreign exchange reserves <0 D H, increase F <*== /

4 #tatistical discrepancy <D or *=

-5 (llocation of special dra!ing rights <D=

(t any point in time, the &o) must balance, i.e. the sum of debt and credit items

is "ero.

⇒ C( D )( D 9#& F 5



or C( F J?( <assuming )( D 9#& F ?(=

Thus, a current account <C(= deficit is financed by a positive capital account

<?(=, i.e. by capital inflo!.

( net debtor nation is one !hose stock of foreign financial assets held by

domestic residents is less than the stock of domestic financial assets held by

foreign residents.

C( D )( F J9#&

If the 82# is negative <positive= <implying that there is an excess supply of

domestic currency=, then 9#& !ill have to be positive <negative= @ the central

bank finances the deficit by selling 9AB.

%ote that, quite confusingly, a reduction <increase= in 9AB reserves sho!*up

as a positive <negative= number in 9#&. 0

Bxample+ $hat is balance of payments disequilibriumK Can a country run a balance of

payments deficit indefinitelyK :sing a simple diagram, explain ho! balance of payments

disequilibria are self*correcting under flexible exchange ratesK 2o! can balance of payments

disequilibria be corrected under fixed exchange ratesK

(ns!er+ &alance of payment <&o)= disequilibrium means that the current account deficit

<surplus= is not exactly matched by capital account surplus <deficit= and thus the authorities

are loosing <accumulating= official settlements balances or international reserves.

%o, a country can not run a &o) deficit indefinitely because eventually it !ill run out of

international reserves.

&o) ad3ustment under flexible exchange rates

B #

&

(



;

Luantity of 9AB

The foreign exchange market is in initial equilibrium at point ( !here imports <giving rise to

demand for 9AB= are equal to exports <providing supply of 9AB=. That is, the current

account is in balance so the there is no implied change in international reserves <represented

here by 9AB=. %o!, suppose that due to an exogenous shock, the demand for imports

increase. This !ill shift the demand curve to the right and the economy !ill settle at a ne!

equilibrium, point &. The current account !ill be in deficit <due to increased imports=. If the

exchange rate is flexible, then it !ill depreciate <it is higher at point & than at (=, current

account !ill improve and eventually !ill be in balance again. 1

&o) ad3ustment under fixed exchange rates

B

#

#

;

&

( C

;

Luantity of 9AB

(fter an increase in imports, there !ill be pressure on the exchange rate to depreciate

<economy !ill tend to go to point &=. &ut, if the exchange rate is to be kept fixed then the

monetary authority !ill intervene and !ill meet the increased demand for 9AB <due to an

increase in imports= by selling 9AB <international reserves=. Thus, the supply curve !ill

shift do!n and the economy !ill reach equilibrium at point C.



Bxample+ ( current account surplus is not al!ays a sign of health a current account deficit

is not al!ays a sign of !eakness. Comment on this statement keeping in vie! the broad

balance of payments concept.

(ns!er+ &asic balance of payments identities sho! that a countrys current account balance

must equal its net capital flo!s from abroad. ( current account deficit means that a country is

experiencing net capital inflo!s form abroad or a capital account surplus, meaning that the

country is a net debtor. &eing a net debtor <or creditor= is not necessarily NgoodO or NbadO.

Capital inflo!s may add to a nations capital stock and increase an average residents ability

to purchase goods and services in the future. G

Money (ccounting

(n important aspect of the C( is that it indicates the rate at !hich the economy

in the aggregate is adding to its net external assets. In terms of &o) concepts,

C( surplus equals the increase in net 9#& plus the rate of private capital

outflo!.

C( F P%( <-=

The &o) and the Monetary &ase

&alance #heet of the Central &ank

(ssets 8iabilities

%(

C 2

!here %( stands for net foreign assets and C stands for domestic credit.

omestic

#

M is determined as+

M h2

#

F

!here h is money multiplier. If assume h F -⇒ M F 2 .



:sing the balance sheet identity+

%( C M

cb

F D

or %( C M

cb

P F P D PH

or %( M C

cb

P F P J P <=

Thus, using equation <-= and <= !e can see that to avoid a current account

deficit, C creation has to be held in line !ith the gro!th in M.

points+

i= Can understand the &o) stabili"ation programs conducted by the IM. To

make the program !ork, the IM imposes domestic credit ceiling that !ill

ensure that the central bank does not distort the C( targets by excessive

financing of government deficits or by loans to the domestic banking system.

ii= If the central bank intervenes in the 9AB market by buying or selling

9AB <to keep BA fixed=, there !ill be a change in the %( position and a

corresponding change in M. Thus, 9AB changes automatically change the

stock of M <and an automatic ad3ustment process for the external balance=. In

deficit countries the

#

M !ill be contracting, !hile in surplus countries it expands.

The C(, Credit Creation and eficit inance

irst, !e !rite the consolidated banking systems <commercial banks and

central bank combined= identity+

%( M C



b

P F P J P </=

Can !rite PC as+

g nb

PC F PC D PC <0=

!here

g

PC is credit to government and

nb

PC is credit to non*bank public.

(ssuming that the governments budget deficit is financed by government

borro!ing form the banking system or abroad, !e have

g g

> J T F PC J P%( <1=

:sing </=, <0=, <1=

< = < =

b nb g

P%( F PM J PC D T J > J P%(

ecrease in the banking systems net external asset position have as their

counterpart either an increase in credit to the public in excess of a rise in money

or a budget deficit that is financed by the domestic banking system.

DISEQUILIBRIUM IN BALANCE OF PAYMENT

Disequilibrium in balance of payment

The balance of payment of a country is said to be in equilibrium when the demand for foreign exchange isexactly equivalent to the supply of it . The balance of payment is in disequilibrium when there is either a

surplus or deficit in the balance of payments. When there is deficit in the balance of payments, the

demand for foreign exchange exceeds the demand for it.

A number of factors may cause disequilibrium in the balance of payments. These causes may be broadly

categorised into:

1. Economic factors ;

2. Political factors ;



3. Sociological factors.

1. Economic factors

i. Development Disequilibrium

Large scale development expenditures usually increase the purchasing power, aggregate demand and

prices, resulting in substantially large imports. The development disequilibrium is common in developing

countries, because the above factores, and large scale capital goods imports needed for carrying out thevarious development programmes, give rise to a deficit in the balance of payments.

ii. Capital Disequilibrium

Cyclical fluctuations in general business activity are one of the prominent reasons for the balance of

payments disequilibrium. As Lawrance W. Towle points out, depression always brings about a drastic

shrinkage in world trade, while prosperity stimulates it. A country enjoying a boom all by itself ordinarily

experiences more rapid growth in its imports than its exports, while the opposite is true of other countries.

But production in the other countries will be activated as a result of the increase exports to the boom

country.

iii. Secular disequilibrium

Sometimes, the balance of payments disequilibrium persists for a long time because of certain secular

trends in the economy. For instance in a developed country, the disposal income is generally very high

and, therefore, the aggregate demand, too, is very high. At the same time, production costs are very high

because of the higher wages. This naturally results in higher prices. These two factors-high domestic

prices may result in the imports being much higher than the exports. This could be one of the reasons for

the persistent balance of payments deficits of the USA.

iv. Structural disequilibrium

Structural changes in the economy may also cause balance of payments disequilibrium. Such structural

changes include the development of alternative sources of supply, the development of better substitutes,

the exhaustion of productive resources, the changes in transport routes and costs, etc.

2. Political FactorsCertain political factors may also produce a balance of payment disequilibrium. For, instance a country

plagued with political instability may experience large capital outflows, inadequacy of domestic investment

and production, etc. These factors may sometimes, cause disequilibrium in the balance of payments.

Further factors like wars, changes in world trade routes, etc. may also produce balance of payments

difficulties.

3. Social Factors

Certain social factors may also produce a balance of payments. For instance, changes in tastes,

preferences, fashion, etc. may affect imports and exports and thereby affect the balance of payments.

Correction of disequilibriumA country may not bother about surplus in the balance of payment; but every country strives to remove or

at least to reduce, a balance of payment deflects. A number of measures are available to correcting the

disequilibrium. Some of them as follows

1. Automatic corrections

The balance of payment may be automatically corrected under the paper currency standard. The theory

of automatic correction is that if market forces of demand & supply are allowed to have free play the

equilibrium will automatically be restored in course of time.

balance-of-payments-disequilibrium.docx

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