CAUSES OF ADVERSE BALANCE OF PAYMENTS

1. Natural factors
Natural calamities like drought or flood may easily cause disequilibrium in balance of payments. These natural calamities can adversely affect agricultural and industrial production. Exports may decline and imports may go up, causing a setback in the countrys balance of payment.

2. Trade cycles
Business fluctuations caused by the operation of trade cycles may also result in disequilibrium in countrys balance of payments. For instance, if there occurs a recession in foreign countries, it may induce a fall in the exports and exchange earning of the country concerned, hence resulting in a disequilibrium in the balance of payments.

3. Political instability
Political instability results in disrupting the productive potential within the country, thereby causing a decline in exports and an increase in imports.

4. Relatively high rate of inflation

High rate of inflation as compared to other countries makes the goods produced by that country relatively expensive. As a result, its exports decline and the balance of payment runs into a deficit.

5. Trade restrictions by other countries

Sometimes other countries impose heavy custom duties or fix quotas or ban imports from a country. It results in lower exports of that country.

6. Inelastic demand for machinery and industrial goods

The demand for these goods by less developed countries is inelastic because these less developed countries have no choice since there is shortage of such goods in these countries and to increase their growth rate they are going to need such goods. Hence their imports remain high.

METHODS TO CORRECT BALANCE OF PAYMENTS

(i) Depreciation or devaluation of the home currency which makes the imports costlier and uncompetitive, whereas exports become more competitive. (ii)Protectionist measures resulting in either partial restriction or complete ban on imports or increase in cost of imports. (iii)Domestic deflation by reducing the supply of money and thereby aggregate domestic demand so that the quantity of imported goods decreases. (Iv)Increase in domestic interest rate to attract deposits from foreign countries. (v)Import substitution to reduce the overall quantity of imports. (vi)Exchange control regulations to restrict outflows of funds from the home country. (vii)Stimulating exports by providing subsidies and tax holidays to export-oriented industries.

ECONOMIC OBJECTIVES OF GOVT (i)To achieve economic growth:

One of the major aims of the governments economic policy is to achieve economic growth and increase the national income per head. This way the GDP level will rise resulting in improvement in standards of living of the people, higher production and more tax collection.

(ii)To control inflation:

To have a stable price level is important so that the real income of the people can increase with the passage of time and the standard of living can rise too.

(iii)To achieve full employment:

This is also an important aim of the government as the government pays unemployment benefits to the people. If there is full employment then the government will save that money and also be able to collect more taxes. This would help the government to increase provision of public and merit goods. There will also be a high standard of living of the people.

(iv)To achieve a balance between imports and exports:

Deficit in the BOT will be harmful for a countrys economy. Economic growth would stop as more imports mean local industries are suffering from severe competition from abroad.

Accelerator
It is the ratio between the change in induced investment and a change in national income occurring through a change in consumption. W = K/Y Limitations of accelerator principle Following are some of the limitations of the accelerator principle: (i) Temporary change in demand:

It is applicable only when there is a permanent change in demand. When the rise in demand is temporary, the entrepreneurs instead of increasing their investment may only employ the labourers to work over-time to meet the additional demand. Thus, in case of temporary change in demand, the principle of accelerator does not operate. (ii) Business expectations:

Entrepreneurs make investment keeping in view the expected rate of profitability. So business expectations play a vital role in determining the induced investment rather than the current changes in the demand for consumer goods. (iii) Concept of capital-output ratio:

It explains the concept of capital-output ratio for the whole economy. However, in reality the capital-output ratio cannot be generated for the whole economy. This ratio varies from one industry to another. Hence, the concept of accelerator is confined to an industry rather than being applicable to the whole economy.

(iv)

Constant aggregate demand:

Increase in demand for a particular consumer good may lead to a reduction in demand for a substitute. Therefore, an increase in investment in one industry may reduce the investment in another industry and hence the aggregate demand for whole economy may remain constant. In this case, the aggregate induced investment will not change and hence the concept of accelerator would not apply. (v) Non-availability of financial resources:

The accelerator principle emphasizes that induced consumption results in an increase in induced investment. However, due to financial constraints, it may not be possible to increase the investment level. Under such circumstances, the accelerator theory would not work despite having induced consumption. (vi) Difference in durability of machinery:

It assumes that the machines used for production purposes have equal life-span and durability. Such an assumption is not practical. (vii) Lack of productive capacity:

The principle of accelerator states that induced consumption results in an increase in induced investment. But in cases where the capital goods industries are already operating at full capacity and the production of additional machines is not possible i.e. in the short-run, the theory of accelerator ceases to apply. (viii) Long run investment projects:

Autonomous investment takes place in long term projects which is known as the income inelastic investment. In the case of these projects, the concept of induced investment becomes irrelevant because induced investment is income elastic investment. Thus, the concept of accelerator does not apply to long term projects.

Investment measures that should be taken:

(i)Control interest rates: By keeping interest rates low, for example, the government might encourage a higher volume of investments, whereas by allowing interest rates to rise, the government would probably cause the volume of investment to fall. Government can influence interest rates. (ii)Provide direct encouragement to investing firms: By offering investment grants, perhaps directed at particular regions, by lowering the cost of investment i.e. cost of doing business, by improving the rule of law, by providing tax incentives etc. (iii)Seek to stimulate business confidence: By developing and announcing an economic policy for continued growth which should be consistent with the stated goals. Frequent and sudden changes in economic policy results in loss of business confidence. (iv)Encourage technological developments: By financing research schemes of its own as well as those of private firms. In the long run, investment in education might be significant for the strength of innovative research and development by the countrys industries. (v)Influencing the volume of consumption: Sometimes the government indirectly influence the level of investment, for instance a policy to control the growth in the money supply, would help in credit control and would in turn affect consumer spending, especially in consumer durable goods. Changes in consumption affects investment levels, with the influence of the accelerator.

(vi)Government spending: Higher government spending in infrastructure cerates demand which stimulates investment by the private sector.

Recession
A Recession is a recurring period of decline in total output, income and employment and usually prevails for a period of 6-12 months. It is marked by a period of decline in aggregate demand and widespread contraction of many sectors of the economy. The economic characteristics which are most commonly observed during a recessionary period are: (i) decline in demand for labour followed by layoffs and increase in unemployment rates. (ii) fall in demand for capital goods, consumer durable goods and luxury items and prices of these products show a marked downward trend. (iii) sharp drop in business profits. (iv) decline in volume of shares traded in the stock exchanges and fall in their prices. (v) decline in the demand for credit accompanied by drop in interest rates.

Financial intermediary
Financial intermediary is an institution which links lenders with borrowers by obtaining deposits from lenders and then re-lending them to borrowers. They can provide a link between savers and investors. Financial intermediaries include: 1. 2. 3. 4. 5. 6. Banks; Building societies, insurance companies, pension funds, unit trust companies and investment trust companies.

Example: A person might deposit savings with a bank and the bank might use its collective deposits of savings to provide a loan to a company. Role of financial intermediaries: The role of financial intermediaries in an economy, such as banks and building societies, is to provide means by which funds can be transferred from surplus units in the economy to deficit units. The financial intermediaries develop the facilities and financial instruments which make this lending and borrowing possible. They obtain funds by issuing to the public their own liabilities e.g. saving deposits and then use this money to lend or invest in entities that need the money. In this way financial intermediaries mediate between original savers and final borrowers.