Chapter Three

The Balance of Payments

1
 What is the balance of payments?

• The balance of payments (BOP) is a statistical

statement that systematically summarizes the
economic transactions of an economy with the rest
of the world for a specific period of time such as a
quarter or a year.

• The economic transactions of an economy consist of

imports and exports of goods, services, and capital,
as well as transfer payments, such as foreign aid and
remittances.

2
 The balance of payments
• The balance of payments is the most important
statistical statement for any country because of the
following reasons:

a) It reveals how many goods and services the country

has been exporting and importing,

b) Whether the country has been borrowing from or

lending money to the rest of the world,

c) Whether or not the monetary authorities (usually the

central bank) has added to or reduced its reserves.

3
 Balance of payments accounting and
accounts
• In an accounting sense, the balance of payments has to
balance.
• This is so because it is based upon double – entry book –
keeping principle. That is, transactions are classified as
credits or debits.
• Thus, the total amount of debits must equal to the total
amount of credits.
• Credit transactions are those that involve the receipts of
payments from foreigners (a plus in the accounts); while
the debit transactions are those that involve the making of
payments to foreigners (a minus in the accounts).

4
 Sub-accounts in the balance of payments
• Traditionally, the balance of payments statistics is
divided into two main sections: the current account
and the capital account.
• Each of the two main account are further sub –
divided.
• The current account items refer to income flows; while
the capital account records changes in assets and
liabilities.
• Other remaining items are the official reserve and the
balancing item (statistical discrepancy or errors and
omissions).

5
 Sub-accounts in the balance of payments

• 1. The Trade Balance

• Records transactions arising out of the exports and imports

of visible items (goods). It is also refereed to as
merchandise trade.

• Export receipts are recorded as credits while import

expenditures are recorded as debits.

• Furthermore, the conventional method is that exports are

valued at FOB (Free on board) and imports are valued at
CIF (cost, insurance, and freight of charged in full).

6
 Sub-accounts in the balance of payments

• FOB is a term which describes a price for

valuation of a good which is calculated on the
basis of the process of manufacturing, and does
not include the cost of transporting the good to
the consumer. Where a firm prices its goods at
FOB, we can be sure that the consumer pays the
transport costs.

• On the other hand, CIF valuation is the pricing

which includes all the costs of delivering the
good to the point of consumption.

7
 Sub-accounts in the balance of payments
• 2. The Current Account Balance
• Is the sum of the visible trade balance and the invisible balance.

• The merchandise trade forms the most important international

transaction of most of the countries.

• The invisible balance shows the difference between revenue

received for exports of services and payments made for
imports of services such as shipping/transportation, insurance,
banking (payments of interest and dividend), consulting,
brokerage and tourism.

8
 Sub-accounts in the balance of payments
• In addition, receipts and payments of interest, dividends
and profits are recorded in the invisible balance because
they represent the rewards for investment in overseas
companies (bonds and equity); while payments reflect the
rewards to foreign residents for their investment in the
domestic economy.

• Moreover, unilateral transfers (unrequited transfers or

gifts) are recorded in the invisible balance.

• These are receipts or payments for which there is no

corresponding quid pro quo (such receipts or payments are
just for free).

9
 Sub-accounts in the balance of payments
• Unilateral transfers or unrequited transfers can take three forms:
private unrequited transfers or gifts such as migrant workers’
remittances to their families back home, official unrequited
transfers such as "pure aid or grant" by governments (that is,
transactions on which government expects no return), and
reparation payments or indemnities which are compensation
for loss or damage.

• Generally, the current account contains three categories on the

receipts side: exports of merchandise, exports of services, and
income receipts on assets/investments abroad. The three
counterparts on the payments side are: imports of merchandise,
imports of services, and income payments on foreign assets.

10
 Sub-accounts in the balance of payments

• 3. The Capital Account Balance

• The capital account records transactions concerning the
movement of financial capital into (capital inflows are credit
items) and out of the country (capital outflows are debit
items).

• Capital comes into the country by borrowing, sales of

overseas assets, and investment in the country by foreigners.

• Some of these investment are real (for example, land,

buildings, and machinery) while others are financial (for
example, bonds and bank deposits).

11
 Sub-accounts in the balance of payments

• Official capital flows refers to governments and

central banks.

• Capital inflows other than official are foreign

private capital.

• If, for example, an American firm invests $100

million in Ethiopia, this transaction will be
represented as a debit in the US balance of
payments, and as a credit in the balance of
payment of Ethiopia.
12
 Sub-accounts in the balance of payments

• 4. Statistical Discrepancy or Net Errors and

Omissions

• Given the huge statistical problems involved in

compiling the balance of payments statistics,
there will usually be a statistical discrepancy.

• Thus, to ensure that the credits are equal to the

debits, it is necessary to incorporate a statistical
discrepancy for any difference between the sum
of credits and debits.
13
 What are the possible sources of error?

1. It is impossible to keep track of all the transactions between

domestic and foreign residents;
2. Many of the reported statistics are based on sampling
estimates and, thus do not reflect the actual transactions;
3. The desire to avoid taxes means that some of the
transactions in the capital account are underreported. Some
dishonest firms may deliberately under-invoice their exports
and over-invoice their imports to artificially deflate their
profits;
4. There could be “leads and lags.” For example, the good has
already been imported, but the payment could be delayed.

14
 Sub-accounts in the balance of payments
• 5. The Official Reserve Account (Official Settlement Balance)

• The summation of the current account balance, capital account

balance and the statistical discrepancy gives the official
settlements balance.

• The balance on this account is important because it shows the

money available for adding to the country's official reserves or
paying off the country's official borrowing.

• Official reserves constitute the nation’s gold holdings, special

drawing rights*, and official foreign currency holdings.
*Special Drawing Rights are international reserves created by the IMF to
supplement other international reserves and distributed to member nations
according to their quotas in the fund.

15
 Sub-accounts in the balance of payments
• Such reserves are held primarily to enable the central bank
to purchase its currency should it wish to prevent it
depreciating.

• Any official settlements deficit has to be covered by the

authorities drawing on the reserves, or borrowing money
from foreign central banks or the IMF (recorded as a plus in
the accounts).

• If, on the other hand, there is an official settlements surplus

then this can be reflected by the government increasing
official reserves or repaying debts to the IMF or other
sources overseas (a minus since money leaves the country).

16
Simplified example of the annual balance of payments accounts

17
Balance of Payments Disequilibria
• The balance of payments always balances since each credit
in the account has a corresponding debit elsewhere.

• This naturally raises the question as to what is meant by a

balance of payments deficit or surplus?

• While the overall balance of payments always balances this

does not mean that each of the individual accounts that
make up the balance of payments is necessarily in balance.

• For Instance, the current account can be in surplus while

the capital account is in deficit.

18
Balance of Payments Disequilibria
• Thus, when talking about a balance of payments deficit or
surplus economists are really saying that a subset of items
in the balance of payments are in surplus or deficit.

• There are a number of factors that may cause disequilibria

in the balance of payments.

• These factors can broadly be categorized into:

• i) Economic factors
• ii) Political factors
• iii) Sociological factors

19
Balance of Payments Disequilibria
i) Economic Factors

These are further categorized into:

a) Development Disequilibrium,
b) Cyclical Disequilibrium,
c) Secular Disequilibrium, and
d) Structural Disequilibrium.

20
Balance of Payments Disequilibria
• a) Development Disequilibrium: large scale
development expenditures  increased
purchasing power  increased aggregate
demand and prices  substantially large
imports, especially capital goods imports for
development programs in the case of
developing countries leading to a deficit in the
balance of payments.

21
Balance of Payments Disequilibria
• b) Cyclical Disequilibrium: These refer to cyclical
fluctuations of the general business activities (recall
business cycles: peak, recession (depression is severe
or prolonged or protracted recession), trough, and
recovery). For example, depression always brings about
a drastic shrinkage in world trade while prosperity
stimulates it.
• A country enjoying a boom will ordinarily experience a
more rapid growth in its imports than in its exports,
while the opposite will be true of other countries. But
production in the other countries will be activated as a
result of the increased exports to the former.

22
Balance of Payments Disequilibria
• c) Secular Disequilibrium: The balance of payments
disequilibria may persist for longer periods due to
secular trends (sustained increases) in the economy.
• For example, in a developed country, the disposable
income is generally very high where aggregate demand
is also high. At the same time production costs are very
high due to higher wages, resulting in higher prices.
These two factors, high aggregate demand and higher
domestic prices result in imports being higher than
exports.

23
Balance of Payments Disequilibria
• d) Structural Disequilibrium: Structural
changes in the economy may also cause a
balance of payments disequilibria. Such
structural changes include, for example,
development of alternative sources of supply,
development of better substitutes, exhaustion
of productive resources or changes in
transport routes and costs.

24
Balance of Payments Disequilibria
• ii) Political Factors: For example, if a country is
plagued with political instability, this will cause
large capital outflows (because of security
reasons) inadequacy of domestic investment
and production. Furthermore, factors like war or
changes in the world trade routes could also
produce similar difficulties.

• iii) Social Factors: changes in tastes, preferences,

and fashions may affect imports and exports and
thereby affect the balance of payments.

25
 Correction of BOP Disequilibria
• In general, a country may not bother about a
surplus in the balance of payments. However,
every country strives to remove or at least reduce
the balance of payments deficit.

• Measures for correcting balance of payments

disequilibria may be grouped into two:

• i) Automatic Measures
• ii) Deliberate Measures

26
 Correction of BOP Disequilibria
• i) Automatic Correction
• The theory of automatic correction is that if the market forces
of demand and supply are allowed to have free play, in course
of time, equilibrium will automatically be restored.

• For example, assume that there is a deficit in the balance of

payments.

• This means the demand for foreign exchange exceeds its

supply and this results in an increase in the exchange rate
(price) and a fall in the external value of the domestic
currency.

27
 Correction of BOP Disequilibria
• An increase in the exchange rate (or a fall in the
external value of the domestic currency) will make
exports of the country cheaper and imports dearer
than before.

• Consequently, the increase in exports and the fall in

imports restore the balance of payments equilibrium.

• Under the fixed exchange rate system, balance of

payment disequilibria may be corrected by
adjustments in a) price, b) interest rate, c) income,
and d) capital flows.

28
 Correction of BOP Disequilibria
• a) Price Adjustments: Under the gold standard, for
example, there had to be a gold outflow from a deficit
country to a surplus country.

• This results in a fall in money supply in the deficit

country and an increase in money supply in the surplus
country leading to a rise in price in the surplus country.

• A rise in prices in the surplus country encourage

imports and discourage exports, leading to restoration
of balance of payments equilibrium in due course.

29
 Correction of BOP Disequilibria
• b) Interest Rate Adjustment: A monetary effect of BOP surplus or
deficit, besides the price effect, is its impact on the short term
interest rates.

• For example: the contraction of money supply resulting from the

balance of payments deficit leads to a rise in interest rates.

• This will encourage investors in the deficit country where the

interest rate has risen to withdraw their funds from abroad and
deposit in the home country. Similarly, foreigners will be
encouraged to send money to the deficit country where the interest
rate has risen.

• These changes will contribute to the restoration of BOP equilibrium.

30
 Correction of BOP Disequilibria
• c) Income Adjustments: Although the classical
economists neglected the effect of income
adjustments, the Keynesian approach to BOP
demonstrated that under the fixed exchange rate
system, changes in income will help restore BOP
equilibrium automatically.

• d) Capital Flows: As mentioned above, changes in

interest rates will affect capital flows between the
deficit and the surplus nations which in turn
affects BOP equilibrium.

31
 Correction of BOP Disequilibria
• ii) Deliberate measures

• These are widely employed today, and refer to

correction of disequilibria through
deliberate/purposeful policy interventions.

• These include, for example,

• a) Monetary measures
• b) Trade measures
• c) Others
32
 Correction of BOP Disequilibria
• a) Monetary Measures: includes monetary contraction /
expansion, devaluation/revaluation, and exchange
controls.

• Monetary contraction/expansion: For example, in the case

of balance of payments deficit, contraction of money
supply is required. This is so because:
• Contraction of MS  reduction of purchasing power 
reduction of aggregate demand  reduction of domestic
prices  reduction of demand for imports. The fall in
domestic prices  increase exports. Increased exports and
decreased imports will correct the BOP deficit.

33
 Correction of BOP Disequilibria
• Devaluation/Revaluation: These are expenditure switching
policies. Devaluation switches the nation’s expenditures
from foreign to domestic goods, while revaluation switches
expenditures from domestic to foreign goods.

• Exchange Controls: Under exchange control, the

government or the central bank assumes complete control
over the foreign exchange reserves and earnings of the
country. The recipients of foreign exchange, like the
exporters, are required to surrender foreign exchange to
the government/central bank in exchange for domestic
currency. By virtue of its control over the use of foreign
exchange, the government can control imports.

34
 Correction of BOP Disequilibria
• Trade measures: include export promotion measures (measures
that facilitate, for example, horizontal diversification and vertical
diversification) and measures to reduce imports.

o Export promotion: encourage exports by abolishing or reducing of

export duties, providing export subsidies, and by giving export
incentives such as monetary, fiscal, physical, and institutional
incentives and facilities.

o Import Control: imports may be controlled by imposing import

duties, restricting imports through import quotas, through
licensing, and even prohibiting the import of certain goods.

35
 Correction of BOP Disequilibria
• Other measures include:
• Foreign loans,
• Incentives for foreign investment,
• Tourism development,
• Incentives for foreign remittances, and
• Import substitution

36
 Approaches to Balance of Payments
• The basic question here is: how does the change
in exchange rates impact on the balance of
payments?

• There are three approaches to address this

question:

1. The Elasticity Approach

2. The Absorption Approach, and
3. The Monetary Approach

37
 The Elasticity Approach
• This approach provides an analysis of what happens to the
current account balance when a country devalues its currency.

• The analysis was pioneered by Alfred Marshall, Abba Lerner and

latter extended by Joan Robinson (1973) and Fritz Machlup
(1955).

• It should be noted that the elasticity approach to the balance of

payments is based on partial equilibrium analysis, which
assumes that income and prices of other commodities are kept
constant.

• For discussions in consecutive sections exchange rate is defined

as domestic currency per unit of foreign currency and hence
devaluation/depreciation is given by a rise in exchange rate.

38
 The Elasticity Approach
• Furthermore, the approach deals with only the current
account and ignores the capital account of the balance of
payments.

• The model makes some simplifying assumption, i.e., it

focuses on demand conditions and assumes that the supply
elasticities for the domestic export good and foreign
import good are perfectly elastic, so that changes in
demand volumes have no effect on prices.

• In effect, these assumption mean that domestic and

foreign prices are fixed so that changes in relative prices
are caused by changes in the nominal exchange rate.

39
 The Elasticity Approach
• Starting from a position of equilibrium in the current account, the
Marshall – Lerner conditions state that:

1. If the sum of the foreign elasticity of demand for exports (η X ) and

the home country elasticity of demand for imports (ηm) is greater
than unity, that is, η X + η m > 1, then devaluation will improve the
current account,

2. If η X + η m < 1, then devaluation will lead to a deterioration in the

current account, and

3. If η X + η m = 1, then devaluation will neither improve nor worsen the

current account.

40
 The Elasticity Approach
• Theoretically, there are two effects following
devaluation:

1. The price effect: exports become cheaper measured

in foreign currency, while imports become more
expensive measured in the home currency. The price
effect contributes to worsening of current account.

2. The volume effect: the fact that exports become

cheaper should encourage an increased volume of
exports, and the fact that imports become more
expensive should lead to a decreased volume of
imports. The volume effect contributes to the
improvement of the current account.
41
 The Elasticity Approach
• The net effect depends upon whether the price or
volume effect dominates.
• The possibility that a devaluation may lead to a
worsening rather than improvement in the balance of
payments led to much research into empirical estimates
of the elasticity of demand for exports and import.
• Two camps of Economists:
1. Elasticity Optimists’ – who believed that the sum of the
two elasticities tended to exceed unity, and
2. Elasticity Pessimists’ – who believed that the two
elasticities tended to be less than unity.

42
 Some Empirical Evidences on
the Elasticity Approach
• Higher import prices caused by devaluation could
stimulate increases in domestic prices of non-traded
goods.

• The consequence is a rise in inflation and this could

potentially reduce the benefits of devaluation.

• Furthermore, devaluation is an unpopular policy,

especially in small countries that are extremely
dependent on imports as a source of food and
necessities.
43
 Some Empirical Evidences on
the Elasticity Approach
• A general consensus accepted by most economists is that
elasticities are lower in the short run than in the long run,
in which case the Marshall - Lerner condition may only hold
in the medium to long-run.

• In other words, in the short run it may be difficult to react

to price changes by reallocating factors of production.

• In the long run, however, it is much probable that the

production pattern will alter according to price changes
and the demand for imports will therefore be more elastic
(i.e., responds to changes in prices).

44
 Some Empirical Evidences on
the Elasticity Approach
• It was also argued that a devaluation may work better for
industrialized countries than for developing countries.

• Many developing countries are heavily dependent upon

imports so that their price elasticity of demand for imports
is likely to be very low.

• For industrialized countries that have to face competitive

export markets, the price elasticity of demand for their
exports may be quite elastic.

• The implication of the Marshall – Lerner condition is that

devaluation may be a cure for some countries balance of
payments deficits but not for others.

45
 The J - Curve Effect
• Most economists and policy makers believe that currency
devaluations bring about competitive advantage in
international trade.

• In other words, when a country devalues its currency,

exports become cheaper relative to its trading partners,
resulting in an increase in the quantity demanded.

• Devaluation as a policy prescription is mainly aimed at

improving the trade balance. However, there is a time lag
before the trade balance improves following devaluation.

46
 The J - Curve Effect
• The short run and long run effects of devaluation on the
trade balance are different.

• Theoretically, the trade balance deteriorates initially after

devaluation and some time along the way it starts to
improve until it reaches its long run equilibrium.

• That is, initially devaluation of a currency causes a current

account deficit, and after a period of time the current
account moves in the direction of a surplus.

• The time path through which the trade balance follows is

a J-curve.
47
The J - Curve Effect
• The J curve is so named
since it describes the
shape of the time path
the current account
figures may follow if
time is plotted on the
horizontal axis and the
balance of trade on the
vertical.

48
 The J - Curve Effect
• A nation's trade balance may actually worsen soon
after a devaluation or depreciation.

• In explanation of these events it is usually argued that

the volume of exports and imports respond only slowly
to the change in relative prices that the devaluation
has introduced and therefore imports remain high and
exports low in the immediate post-devaluation period.

• In other words, there is a tendency that the domestic -

currency price of imports would rise faster than export
prices soon after devaluation.

49
 The J - Curve Effect
• To put it differently, if consumers and producers are
unresponsive in the short run, depreciation actually
leads to a short run worsening in the current account
before it ultimately gets better.

• Only after international contracts are renewed to

reflect the new exchange rate does the quantity of
imports and exports begin to change.

• That is, imports will begin to decline and exports will

begin to rise. Once this occurs, the country's current
account balance will begin to improve.

50
 The J - Curve Effect
• Why Time Lag after Devaluation?

• The time lag comes about as an impact of several lags such

as recognition, decision, delivery, replacement and
production.

• Recognition Lag: Following a real depreciation, traders take

time to recognize the changes in market competitiveness.

• This may take longer in international markets than in

domestic markets before information is passed on the
stakeholders because of distance and language problems.

51
 The J - Curve Effect
• Decision Lag: Some time is spent on deciding on what business
relationships to venture into and for the placement of new
orders.

• Delivery Lag: There is a delivery lag that explains the time taken
before new payments are made for orders that were placed
soon after the price shocks.

• Replacement Lag: Procurement of new materials may be

delayed to allow inventories of material to be used up.

• Production Lag: There is a production lag before which

producers become certain that the existing market condition will
provide a profitable opportunity.

52
 The Inflationary Impact of
Devaluation - Channels
• The inflationary impact of devaluation may come through
various channels.

• Devaluation increases the domestic prices of imports. If these

imports are final goods, then there is an immediate impact on
the price level. If the imports are intermediate goods, then the
increase in their prices will push up the production costs (cost –
push inflation) of those goods in which they are used.

• The prices of domestically-produced goods may also rise even if

they do not use imported intermediate goods; this will almost
certainly be the case if they (the domestic goods) are close
substitutes for imports, but may come about through a
reduction in the degree of competition within the economy.

53
 The Inflationary Impact of
Devaluation - Channels
• Devaluation may have a second - stage
inflationary impact if the increase in the price
level leads to increased wage demands (cost-
push inflation), and if domestic firms are more
willing to give increases because of the reduction
in competitive pressure from imports.

• The consequences of such inflation will be that it

erodes the impact of devaluation.
54
 The Absorption Approach
• One of the major defects of the elasticity approach is
that it is based upon the assumption that all other
things are equal (or ceteris paribus).

• In other words, the elasticity approach assumes that

devaluation is supposed to work on the balance of
payments through the price (exchange rate) effect.

• The absorption approach is a reaction against the

restrictive assumptions underlying the elasticity
approach.
55
 The Absorption Approach
• The absorption approach emphasizes the macroeconomic
(income) effects of devaluation.

• That is, changes in export and import volumes will have

implications for national income and consequently income
effects need to be incorporated in a more comprehensive
analysis of the effects of devaluation.

• Sidney Alexander (1952) (who named it as the absorption

approach) gave an important evaluation of the income
effect, focusing on the fact that a current account
imbalance can be viewed as the difference between
domestic output and domestic spending (or absorption).

56
 The Absorption Approach
• The model can be explained by using simple mathematical
derivation as follows:

• Y = C + I + G + (X - M) -----------(1)

• And defining domestic absorption as:

• A = C + I + G ----------- (2)

• Rearranging (1), we have

• CA = X - M = Y - A ------------ (3)
• Where, CA is current account, which is the difference between domestic output (Y)
and domestic absorption (A).

57
 The Absorption Approach
• From (3), a current account surplus means (X > M) that
domestic output exceeds domestic spending (Y > A), and
current account deficit (X < M) means that domestic output
is less than domestic spending (Y < A).

• Transforming (3) as changes:

• dCA = dY - dA ---------- (4)

• That is, a change in the current account depends on the

difference between a change in national income and a
change in domestic absorption.

58
 The Absorption Approach
• Thus, if devaluation raises domestic income relative to
domestic absorption, then the current account
improves.

• If, however, devaluation raises domestic absorption

relative to domestic income, then the current account
deteriorates.

• Understanding how devaluation affects both income

and absorption is therefore central to the absorption
approach to the balance of payments analysis.
59
 The Absorption Approach
• If the economy is at less than full employment,
there will be an increase in net exports following
devaluation.

• This will lead to an increase in national income

and employment via the foreign trade multiplier
(the reciprocal of MPS and MPM or
1/MPS+MPM).

• Consequently, devaluation will become an

effective measure in improving the trade balance.
60
 The Absorption Approach
• If, however, the nation was at full employment,
then production or real income (Y) cannot rise,
and depreciation or devaluation can be effective
only if domestic absorption/expenditure (A) falls,
either automatically or as a result of
contractionary fiscal and monetary policies.

• Devaluation has also terms of trade effect. The

terms of trade is the ratio of price of exports to
the price of imports.
61
 The Absorption Approach
• Devaluation tends to make imports more
expensive, resulting in deteriorating terms of
trade.

• The devaluing country has to export a greater

volume in order to import the same volume as
before.

• This represents a loss of real national income

because more units of exports have to be given
up to obtain a unit of imports.
62
 The Monetary Approach
• Studies the impact of devaluation on the purchasing
power (Real Value) of money balances.

• The monetary approach to the balance of payments

was started toward the end of the 1960s by Robert
Mundell and Harry Johnson and became fully
developed during the 1970s.

• The monetary approach represents an extension of

domestic monetarism (stemming from the Chicago
School) to the international economy.
63
 The Monetary Approach
• It views the balance of payments as an essentially
monetary phenomenon. That is, money plays the
crucial role in the long run both as a disturbance and as
an adjustment in the nation's balance of payments.

• The monetary approach to the balance of payments

regards the balance of payments disequilibria as a
reflection of disequilibrium in the money market.

• According to the monetary approach, the balance of

payments should be analyzed in terms of a country's
supply of and demand for money.

64
 The Monetary Approach
• When the quantity supplied of domestic money exceeds
the quantity demanded by the nation's residents, there
will be an outflow of domestic money (a deficit in the
nation's balance of payments) under a fixed exchange rate
system or a depreciation of the nation's currency under
flexible exchange rates.

• On the other hand, when the quantity demanded of

domestic money by the nation's residents exceeds the
quantity supplied, there will be a capital inflow (a balance
of payments surplus) under fixed exchange rates or an
appreciation of the domestic currency under flexible rates.

65
 The Monetary Approach
• In the international payments context, attention is
principally focused on the capital account.

• The monetary approach looks at the implications of

devaluation on capital movements.

• Devaluation raises domestic prices (because imports have

become expensive and thus reduces the purchasing power
(money balance) of domestic residents because of higher
prices.

• The opposite holds for foreigners. That is, the purchasing

power of their money balances will rise.
66
 The Monetary Approach
• The automatic BOP adjustment mechanism in the
monetary approaches is explained under both
the fixed and flexible exchange rate systems.

• Under the fixed exchange rate system, initially let

say Md=Ms, so that BOP is zero.

• Now suppose the monetary authority increases

domestic money supply, with out change in the
demand for money (Ms>Md) and there is a BOP
deficit.
67
 The Monetary Approach
• People who have larger cash balances increase their
purchases to buy more foreign goods and securities. This
tends to raise their prices and increases imports of goods
and foreign assets. This leads to increase in expenditure on
both current and capital accounts in BOP, thereby creating
a BOP deficit.

• To maintain a fixed exchange rate, the monetary authority

will have to sell foreign exchange reserves and buy
domestic currency. Thus, the outflow of foreign exchange
reserves means a fall in interest rate and in domestic
money supply. This process will continue until Ms=Md and
there will again be BOP equilibrium.

68
 The Monetary Approach
• Under flexible (or floating) exchange rate, when there
is a BOP deficit or surplus, changes in the demand for
money and exchange rate play a major role in the
adjustment process without any inflow or outflow of
foreign exchange reserves.

• Suppose the monetary authority increases the money

supply (Ms>Md) and there is a BOP deficit. People
having additional cash balances buy more goods
thereby raising prices of domestic and imported goods
leading to depreciation of the domestic currency and a
rise in the exchange rate.

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 The Monetary Approach
• The rise in prices, in turn, increases the demand
for money thereby bringing the equality of Md
and Ms without any outflow of foreign exchange
rate reserves.

• The opposite will happen when Md>Ms, there is

fall in prices and appreciation of domestic
currency which automatically eliminates the
excess demand for money. The exchange rate falls
until Md=Ms and BOP is in equilibrium without
any inflow of foreign exchange reserves.

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Annex

71
Summary of key balance of payments concepts

72
 Recording of transactions in the
balance of payments
• To understand exactly why the sum of credits and debits in the
balance of payments should sum to zero we consider some
examples of economic transactions between domestic and foreign
residents. There are basically five types of economic transactions
that can take place between domestic and foreign residents:
• 1. An exchange of good/services in return for a financial asset
• 2. An exchange of good/services in return for other goods/services.
Such trade is known as barter or countertrade.
• 3. An exchange of a financial item in return for a financial item.
• 4. A transfer of goods or services with no corresponding quid pro
quo (for example military and food aid).
• 5. A transfer of financial assets with no corresponding quid pro quo
(for example, migrant workers remittance to their families abroad, a
money gift)

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 Recording of transactions in the
balance of payments
• We now look at how each transaction is recorded twice, once
as a credit and once as a debit.
• The table below considers various types of transactions
between US and UK residents and shows how each
transaction is recorded in each of the two countries' balance
of payments.
• The exchange rate for all transactions is assumed to be $2/£1.
• The examples illustrate in a simplified manner the double-
entry nature of balance of payments statistics. Since each
credit in the accounts has a corresponding debit elsewhere,
the sum of all items should be equal to zero.
• This naturally raises the question as to what is meant by a
balance of payments deficit or surplus?

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Examples of balance of payments accounting

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