Chapter 3: Balance of Payment

Balance of Trade:
The Balance of Trade is the difference between the monetary value of a nation's commodity exports
and imports over a certain period.
The balance of trade is the largest component of a nation's current account in its balance of payments
(BOP) accounts.
A country that exports more goods than it imports creates a positive balance of trade, which is called
a trade surplus. When a country imports more goods than it exports, it has a negative balance of
trade, which is called a trade deficit.
Balance of Payment
Balance of Payments is a systematic and summary record of a country’s economic and financial
transactions with the rest of the world over a period of time.
The balance of payments, also known as balance of international payments, encompasses all
transactions between a country’s residents and its nonresidents involving goods, services and
income; financial claims on and liabilities to the rest of the world; and transfers such as gifts.
Thus the balance of payments includes all external visible and non-visible transactions of a country.
Nature of Balance of Payment
Resident of the country includes individuals, corporations and government bodies.
Balance of payment does not include diplomat, tourist, military personnel, worker who temporarily
migrate.
The corporation is the resident of the nation in which it is incorporated but foreign branches and
subsidiaries are not;
International institutions such as the United Nation, the IMF, the World Bank, and the WTO are not
residents of the nation in which they are located.
BOP has time dimension. Usually it is prepared for a calendar year.
Gift, foreign aid, all capital loan and all gold coming and going included in BOP
Purposes of BOP
To inform the government about the international position of the nation.
To help the government in formulating monetary, fiscal, and trade policies.
To inform the exporters and importers about the condition of the country i.e. favorable BOP or
unfavorable BOP. So business man can make decision about the business policy/ strategy.
Balance of payment gives information about the international market demand to the international
businessmen i.e. exporter and importer.
To give information about trade gap. Businessmen do diplomacy with different countries to increase
exports.
The preparation of BOP is impartment because-
BOP statistics help to identify emerging markets for goods and services.
Businessmen can be warned about possible new policies that may alter a country’s business climate,
thereby affecting the profitability of a firm’s operations in that country. For example, sharp rises in a
country’s imports may signal an overheated economy
Business man can easily understand what will be the position of the country’s future foreign exchange
reserve and devaluation of the country’s currency in future
BOP statistics can give signal about increased riskiness of lending to particular countries
Balance of Trade vs. Balance of Payment:

Balance of Trade Balance of Payment

Balance of Trade is a statement that captures the country's Balance of Payment is a statement that captures all
export and import of goods with the remaining world. economic and financial transactions done by the country
with the remaining world.

It keeps records of visible items only, it does not consider The exchange of both the visible and invisible items are
the exchange of invisible terms such as the services recorded.
rendered by shipping, insurance and banking; payment of
interest, and dividend; expenditure by tourists, etc.
Capital transfer are not included in the Balance of Trade. Capital transfer are included in the Balance of payment

It gives a partial view of the country's economic status. It gives a clear view of the economic position of the
country.

It is a component of Current Account of Balance of It includes balance of trade, balance of services, balance of
Payment. unilateral transfers and balance of capital transactions.

It may be favorable, unfavorable or in equilibrium It always remains in balance in the sense that receipt side
is always made to be equal to payment side.
Balance of payment will be unfavorable, if country has
current account deficit and it took more loan from
foreigners. After this, it has to pay high interest on extra
loan and this will make BOP unfavorable.
Defect in BOT cannot be met by BOP Defect in BOP can be met through BOT.
Item include in BOP
The balance of payments is composed of two main aspects.
1. Current account
2. Capital / financial account
If a country has a deficit on the current account, it needs a surplus on the financial account.
Current Accounts: The current account on the balance of payments measures the inflow and outflow of
goods, services and investment incomes as well as unilateral transfers during a particular year.
It reflects net Income of the country. The major components of a current account are:
- The Balance of Trade (only visible items i.e. goods): Goods imported from and exported to the
country.
- Trading of Services: Services received from and rendered to other nations. Service such as tourism,
shipping, banking, insurance etc.,
- Investment income: Investment incomes e.g. dividends, interest and migrants remittances from
abroad.
- Net cash transfers (official and private): Transfers in the form of donations, gifts, aids, etc.
A deficit on the current account (negative balance) means that the value of imports is greater than the
value of exports.
A surplus on the current account (positive balance) means that the value of imports is less than the value
of exports.
Capital Accounts: Capital Account records the movement of capital in the economy due to capital
receipts and expenditure.
It recognizes foreign investment in domestic assets and domestic investment in foreign assets.
It reflects net change in ownership in national assets.
The following are the components of Capital Account:
- Foreign Direct Investment: Investment in a company based in a country by a foreign company.
- Portfolio Investment: Sale and purchase of stocks, bonds, debts and other financial assets to and
from foreigners-individual and governments
- Government loans to the Government of other countries of the world: Borrowing and lending
capital to and from foreign countries, repayment of capital.
A deficit in the capital account means money is flowing out of the country, and it suggests the nation is
increasing its ownership of foreign assets.
A surplus in the capital account means money is flowing into the country which effectively represent
borrowings or sales of assets.
Equilibrium of Balance of payment
Equilibrium is that state of balance of payment over the relevant time period which makes it possible to
sustain an open economy without severe unemployment on a continuing basis.
Types of BOP Equilibrium:
There are two types of BOP equilibrium, i.e., static equilibrium and dynamic equilibrium
 (a) Static Equilibrium: In static equilibrium, exports equal imports including exports and imports of
goods as well as service and the other items on the BOPs – short term capital, long term capital
and monetary gold are on balance, zero.
(b) Dynamic Equilibrium:
- In short term dynamic equilibrium, exports and imports differ by the amount of short-term capital
movements and gold (net) and there are no large de-stabilizing short-term capital movements.
- In long term dynamic equilibrium, exports and imports differ by the amount of long term autonomous
capital movements made in a normal direction, i.e. from the low-interest rate country to those with
high rates.
The distinction between static and dynamic equilibrium in BOP depends upon the time period.
Disequilibrium of Balance of payment:
Though the credit and debit are written balanced in the balance of payment account, it may not remain
balanced always. Very often, debit exceeds credit or the credit exceeds debit causing an imbalance in the
balance of payment account. Such an imbalance is called the disequilibrium.
Disequilibrium may take place either in the form of deficit or in the form of surplus.
1. Cyclical Disequilibrium: Cyclical disequilibrium in the balance of payments arises due to
business cycles. It is caused by
- Different Cyclical patterns of income, or
- Same income pattern but different income elasticity, or
- Identical pattern of income and income elasticity but different price elasticity.
For instance, during boom period, imports may increase due to increase in demand for imported goods
on account of increased income. A country may face deficit in its BOP position on account of increased
imports.
During recession,
- Imports may be reduced due to fall in demand on account of reduced income.
- Exports may increase due to fall in price.
BOP position may show surplus.
Also, the importing countries may face cyclical changes. For instance, there may be recession in the
importing countries, which in turn would reduce demand for imports. Therefore, the demand for exports
will decline and the exporting country may face a trade deficit, which in turn may affect BOP positions.

2. Secular Disequilibrium Secular or long-term disequilibrium in balance of payments occurs

because of
• Change in long term capital movement.
• Long seated and deep-rooted changes in the economy as it moves from one stage of growth to
another,
 In the initial stages of economic development, domestic investment exceeds savings and
imports exceed exports. Disequilibrium occurs due to insufficient capital is available to finance
the import surplus.
 Then comes a stage when domestic savings tend to exceed domestic investment and exports
exceed imports. Disequilibrium arises because the surplus savings exceed investment
opportunities abroad,
 At later stage, domestic savings tend to equal domestic investment and long-term capital
movements on balance become zero
• Technological change: Improved technological change increase productivity, export will be increased
and import will decreased.
3. Structural Disequilibrium: Structural disequilibrium may be of two types:
Structural Disequilibrium at the goods level: Structural disequilibrium at the goods level occurs when a
change in demand or supply of exports or imports alters a previously existing equilibrium or when a
change occurs in the basic circumstances under which income is earned or spent abroad.
- Structural disequilibrium may be caused by a change in taste or technology or in anything which
alters the price of an export upward or downward.
Kumkum Sultana (26th Batch, DM, CU)
 - An increase in the foreign demand for a country’s output is structural disequilibrium. The remedy
is an increase in output of the product and an increase in consumption and imports by the
country.
- A deficit arising from a structural change can be filled by increased production or decreased
expenditure, increased exports or decreased imports.
Structural Disequilibrium at the factor level: Structural disequilibrium at the factor level results from an
inappropriate relation between factor prices and their relative supplies. For instance, if the price of labor is
too high the country will choose lines of comparative advantage in which labor is used more economically
than it should be and import goods with a higher labor content. This will lead to disequilibrium in BOP.
Balance in BOP may still be possible, but only at the cost of unemployed labor.
4. Political Disequilibrium: Political factors can caused for disequilibrium in BOP

•Political instability: If a county’s political condition is not stable then there is no investment which
lead to low output, low supply, more import that create disequilibrium.
• International politics: When the demand of America change then the export of our country
decrease.
• War: If there are any war in the world then BOP face disequilibrium
• International policies: According to some international policies, BOP face disequilibrium
5. Social Disequilibrium: Social values, beliefs, custom, tradition also caused for disequilibrium.
• Changes in fashions, tastes and preferences of the people bring disequilibrium in BOP by
influencing imports and exports
• High population growth in poor countries adversely affects their BOP because it increases the
needs of the countries for imports and decreases their capacity to export.
Method of Correcting Disequilibrium in BOP:
1. Stimulating Exports: Increased exports will earn foreign exchange to make up the deficit. Exports can be
stimulated by developing industries in the export sector. Government can provide both financial and non-financial
assistance to them.
2. Checking Imports:
Imports may be discouraged either by
- Tariffs: Tariff is tax imposed on imports. Also called import duties or custom duties.
- Import Quotas: Under an import quota, fixed amount of a commodity in volume or value is allowed to be
imported into the country during a specified period of time.
- Prohibiting the product totally
- Manufacturing the equivalent product within the country etc.
3. Depreciate the exchange value:
It means a reduction in the exchange value of domestic in terms of gold or foreign currencies. Depreciation
occurs in a free market system.
A currency will depreciate
- When its supply in the foreign exchange market is large in relation to its demand.
- When more domestic currency is required to buy a unit of foreign currency.
The purpose of depreciation of a currency is to cheapen the domestic goods, make exports cheaper and imports
expensive.
4. Devaluation of domestic currency: It means decrease in the external (exchange) value of domestic currency in
terms of a unit of foreign exchange by supplying more domestic currency by the government which makes
domestic goods cheaper for the foreigners.
The difference between devaluation and depreciation is that the former is arbitrary and the latter is the result of
market mechanism.
5. Deflate the currency Deflation means reducing the quantity of money by Central bank through raising the bank
rate, selling the securities in the open market or other methods in order to reduce prices and money income of
the people. Thus, deflationary policy restores equilibrium to the balance
a) By encouraging exports through reduction in their prices and
b) By discouraging imports through the reduction in incomes at home.
Moreover, a higher interest rate in the domestic market will attract foreign funds which can be used for correcting
disequilibrium
6. Exchange Control: Under this method, all the exporters are directed by the central bank to surrender their
foreign exchange earnings. Foreign exchange is rationed among the licensed importers. Only essential imports
are permitted. It is the most widely used method for correcting disequilibrium in the balance of payments.