1.

Balance of payments
Balance of payments (BoP) accounts are an accounting record of all monetary transactions between
a country and the rest of the world. These transactions include payments for the
country's exports and imports of goods, services, financial capital, and financial transfers. The BOP
accounts summarise international transactions for a specific period, usually a year, and are prepared
in a single currency, typically the domestic currency for the country concerned. Sources of funds for
a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus

items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative
or deficit items.
When all components of the BOP accounts are included they must sum to zero with no overall
surplus or deficit. For example, if a country is importing more than it exports, its trade balance will
be in deficit, but the shortfall will have to be counterbalanced in other ways such as by funds
earned from its foreign investments, bay running down central bank reserves or by receiving loans
from other countries.
While the overall BOP accounts will always balance when all types of payments are included,
imbalances are possible on individual elements of the BOP, such as the current account, the capital
account excluding the central bank's reserve account, or the sum of the two. Imbalances in the latter
sum can result in surplus countries accumulating wealth, while deficit nations become increasingly
indebted. The term "balance of payments" often refers to this sum: a country's balance of payments
is said to be in surplus (equivalently, the balance of payments is positive) by a specific amount if
sources of funds (such as export goods sold and bonds sold) exceed uses of funds (such as paying
for imported goods and paying for foreign bonds purchased) by that amount. There is said to be a
balance of payments deficit (the balance of payments is said to be negative) if the former are less
than the latter.
Under a fixed exchange rate system, the central bank accommodates those flows by buying up any
net inflow of funds into the country or by providing foreign currency funds to the foreign exchange
market to match any international outflow of funds, thus preventing the funds flows from affecting
the exchange rate between the country's currency and other currencies. Then the net change per year
in the central bank's foreign exchange reserves is sometimes called the balance of payments surplus
or deficit. Alternatives to a fixed exchange rate system include a managed float where some
changes of exchange rates are allowed, or at the other extreme a purely floating exchange rate (also
known as a purely flexible exchange rate). With a pure float the central bank does not intervene at
all to protect or devalue its currency, allowing the rate to be set by the market, and the central
bank's foreign exchange reserves do not change.
Historically there have been different approaches to the question of how or even whether to
eliminate current account or trade imbalances. With record trade imbalances held up as one of the
contributing factors to the financial crisis of 20072010, plans to address global imbalances have
been high on the agenda of policy makers since 2009.

CONCEPTUAL FRAMEWORK AND LITERATURE REVIEW

Introduction
The purpose of this chapter is three-fold: firstly, to spell out the basic concepts pertaining to the
BoP; secondly, to give a review of the evolution of the BoP adjustment theory to help in
understanding how the theory has evolved over time. Thirdly, to present the various approaches to
the BoP adjustment. The chapter will end with a conclusion and an analytical framework showing
some theoretical linkages between domestic credit and the BoP. In the next section, a review of
some basic BoP concepts is presented. The evolution of the BoP adjustment theory is discussed in
section 2.3, while in section 2.4, the three approaches to the BoP imbalances are presented. An
overview of some previous studies on the MABP will also be done in this section. The chapter will
end with a summary of the theoretical framework and an analytical framework.
2.1 Some definitions
This section highlights the BoP concepts that will be frequently used in the study. To begin with, the
BoP is defined as a summary statement in which, all the transactions of residents of a nation with
the rest of the world are recorded during a particular period of time, usually a calendar or fiscal
year. An international transaction refers to the exchange of a good, service, or an asset (for which
payment is usually required) between the residents of one nation and the rest of the world. The main
purpose of the BoP is to inform the government of the country's international position and to help it
in its formulation of monetary, fiscal, and trade policies. The BoP information is also useful to
banks, firms and individuals directly or indirectly involved in international trade and finance. The
BoP comprises of two main sub-accounts;

(i)

the current account, which deals with trade in goods and services, and

transfers,
.

(ii) the capital account, which records transactions in assets and liabilities.

The sum of the balances on the two accounts, after allowing for errors and omissions, is equal to the
overall balance.
Current Account
The current account of the BoP records all international flows of goods and services, as well as
transfer payments. This account comprises of both visible and invisible items. The visible flows
constitute trade in goods, whereas, invisible flows include services such as insurance,
transportation, banking, tourism and many others. Invisible trade also includes payments for
overseas embassies and military bases, interest, profit and dividends from overseas investments.
The difference between visible exports and imports is known as the trade balance or visible balance,
while the difference between invisible exports and imports is called the invisible balance. In most
developing countries, the trade balance is the most important. Thus, the sum of the trade balance,
balance on invisible items and transfer payments gives the current account balance. In practice, it is
usually common to consider one account of the BoP as an indicator of the performance of the
country's BoP. Most studies have traditionally focused on the current account or trade balance as an
indicator in this respect. Notably, the trade balance is by far the largest component of Uganda's
current account. In fact, fluctuations in the trade account are the primary cause of the movements on
the current account. A deficit on the current account of a nation means that more goods and services
have been imported into the nation than have been sold abroad, while a surplus on the same account
means more goods and services have been exported than imported.
A current account deficit is also defined as the difference between national savings and investments.
Therefore, a deficit can emerge from either a fall in savings or an increase in investments. In this
regard, the sustainability of a given current account deficit will be affected by its source. For
example, a deficit that is accompanied by high investment rates is considered to be less problematic
compared to one associated with a fall in savings (Blejer, 1999:24). This is because high
investments lead to increased productivity and growth in export earnings that will be available to

finance the external debts. However, high investment rates could widen the cunent account deficit
in the short-term through increased demand for imported inputs, but if the investments turn out to
be profitable, no major problems will be created in the long- run. A related issue is the relationship
between the rate of economic growth and the current account balance. Large current account
deficits may be more sustainable if economic growth is high. High GDP growth tends to lead to
higher investments and increased net capital inflows as expected profitability increases.
Capital Account
The capital account records purchases and sales of assets, such as stocks, bonds, and land, other
than the official reserve assets. A capital account can also be divided into two separate parts: (1) the
transactions of the private sector and (2) official reserves transactions, which correspond to the
central banks activities. The capital account measures the change in the net stock of all non reserve
financial assets. Financial reserves are excluded because they do not reflect changes in the market
forces, but rather changes in government policy (Salvatore, 1998:406). The outflows of money from
one country to buy stocks and shares abroad and inflows of resources into the country as foreigners
buy factories and shares is recorded as net investment. Therefore, the sum of all items from net
investment and other net transactions in
financial assets represents the net inflows on the capital account. If a country runs a deficit in its
current account, or spends more abroad than it receives from sales to the rest of the world, the
deficit needs to be financed by selling assets or foreign borrowing. The sale of assets or borrowing
implies that the country is running a surplus on the capital account. Thus, a Current account is of
necessity financed by capital inflows, such that; current account deficit plus the net capital inflows
equals zero. A current account deficit can also be financed by running down the official
international reserves of the concerned country. However, this alternative has limitations since
countries are obliged to hold a certain level of reserves with the Fund. Therefore, in the long run,
governments could address BoP imbalances by reducing import demand or expansion of exports.
Generally, persistent BoP deficits are not desirable and are an indication of macroeconomic
problems in the concerned economy. For example, a deficit indicates that a country's import bill and
its long-term commitments to the rest of the world (private or public or both) have exceeded its
capacity of meeting those obligations through foreign exchange earnings from the national exports
and other inflows. Such a situation puts the country into a fundamental disequilibrium, which
necessitates seeking for foreign borrowing (Hallwood and MacDonald, 1994:20). However, inflows
of foreign loans constitute a claim on the country's foreign reserves and if the deficit persists, all the
country's foreign reserves may be depleted, which could lead to loss of confidence, as the country is

declared unable to repay its foreign debts. Therefore, the BoP imbalances need to be corrected in
order to restore equilibrium in the external sector and to achieve internal macroeconomic stability.

2.2The Balance of Payments Adjustment Theory

This section is concerned with the evolution ofthe BoP adjustment theory. It is useful to examine
how this theory has evolved over time to broaden our understanding of the various adjustment
policies. The BoP adjustment theory has undergone extensive revision over the years. In the early
periods of the development path of international economics, very little attention was paid to the
problem of external disequilibria. Indeed, Dell and Lawrence (1980) observe that the whole range
of policies that are now summed up under the heading of "adjustment process" is fairly new.
Under the gold standard, it was generally believed that the trade and payments balances of countries
would tend to move towards equilibrium automatically without the guidance any person or
institution (Dell and Lawrence, 1980:93). This view originated from the specie-flow analysis
associated with the work of Hume in 17522. It was believed that there was a direct link between
money supply, price level and external balance. A country with a BoP deficit would lose its gold
reserves, resulting into a fall in the monetary base and money supply. Consequently, the fall in
money supply would bring about a fall in the domestic price relative to the foreign price. The
change in the relative price would restrain domestic demand for imports and stimulate foreign
demand for that country's exports, and consequently lead to an Improvement of its BoP. However,
the system did not prevent large instabilities in the prices of exports and imports and the attendant
haphazard shifts in the distribution of income among countries because it was based on unverified
assumptions. For example, in the real world there exists trade restrictions imposed by tarifTs and
other trade controls. Such weaknesses made Hume's mechanism less applicable to the BoP
adjustment problem.
After World War I, when the problems of resource allocation occupied the centre of the stage of the
economic debate, Bickerdike (1920) initiated the concept of external adjustment by the Elasticity
Approach. His concept was developed further in order to analyse the effects of a devaluation on the
trade balance of a devaluing country by Alexander (1952, 1959) and later became synthesised with
the Absorption Approach. The elasticity approach largely focuses on the price elasticities of demand
and

supply

of imports and exports and the Marshall-Lerner condition . It assumes a system of fixed exchange
rates where a devaluation or revaluation may be used to rectify the BoP disequilibrium. However,

under the Floating exchange rate regime, equilibrium is expected to be restored automatically
without government intervention.
The elasticity approach was also widely criticised, mainly for its restrictive assumptions such as the
partial equilibrium analysis of the labour market and wage determination (Alexander, 1952:264).
The approach proved extremely unsatisfactory in the post-war situation of general inflationary
pressure and motivated the introduction of the income-absorption approach. This approach was
largely developed on the basis of research in the IMF under the guidance of Bernstein (Rhomberg
and HeIer (ed.), 1977:2-5). This approach underscores the relationship between the level of national
income and the external sector disequilibrium, and views the balance on the current account as the
difference between national income and national expenditure (absorption). However, the absorption
approach was also criticised for considering only the current account balance, and for ignoring the
effects of the changes in the exchange rates and prices. In the 1950s, attempts were made to
integrate the income-absorption approach with the elasticity approach as well as to
remedy the inadequacies of the elasticity approach, particularly, its partial equilibrium nature (see,
inter alia, Harberger, 1950, Laursen and Matzler, 1950, Alexander, 1952, Johnson, 1956).
After a period of domination by the Keynesians and the intense debates on the insufficiency of
aggregate demand, unemployment and macroeconomic stabilisation during the post-war era,
concern began to be shifted to inflation. The controversy between the Keynesians and Monetarists
strongly influenced the evolution of macroeconomic theory. In the 1950s, members of the
University of Chicago led by Professor Milton Friedman spearheaded a renewal of academic
interest in monetary problems, which became widely known as the "Chicago school of thought" and
later became accepted as "Monetarism"(Choonaratana, 1989:28). In the process, the Keynesian
analytical tools were supplemented, and in some instances replaced by the instruments of monetary
an,!-lysis. Consequently, Polak, of the IMF laid some fundamental concepts in 1957 for the
approach, which was later called the Monetary Approach. This approach is given its most articulate
exposition in a collection of papers edited by Frenkel and Johnson (1976). Although, there is still
controversy about the role of monetarism in solving problems of inflation and unemployment, the
monetary approach is considered very important in the analysis of the BoP problem. Its strength lies
precisely where the other approaches falter and it is relatively easy to apply. A detailed discussion of
this approach is presented in section 2.5 of this chapter.

The

Balance

of

Payments

Adjustment

Policies

The BoP deficit can be adjusted in a number of ways. One method could be restriction imports by
imposing tariffs on them. However, tariffs and other trade barriers cannot be used freely to adjust
the trade balance partly because international organisations such as the IMF, WTO and agreements
like the GATT do not support the use of such measures. Tariffs are becoming less important today
as the world moves to freer trade between nations. In the literature, there are three conventional
approaches to the BoP problem. The first two of these approaches are essentially Keynesian, one is
the "Elasticity Approach" or "Devaluation", it IS also referred to as Expenditure Switching". The
second approach is the "Income-Absorption Approach" or "Expenditure Cutting". The third
approach is the "Monetary Approach". All these approaches are discussed in the next part of this
chapter.
The Elasticity Approach
The elasticity approach basically emerged as a short-run oriented tool of analysis to the BoP
problem during the inter-war period and still survives in one form or another to the present day. It
considers how the responsiveness of imports and exports to changes in the exchange rate determines
the extent to which devaluation can improve the current account balance from the short to long-run.
The approach derives its name from the fact that the improvement in a nation's trade balance largely
depends on the price elasticity of demand for its imports and exports. It assumes a fixed exchange
rate system where devaluation is expected to lower the price of a country's exports abroad and raise
the price of imports in the domestic market resulting into a shift to home produced goods. This shift
is called expenditure switching. As already noted, for this approach to be successful, the MarshallLerner condition must be satisfied. However, if the change in the relative price of exports and
imports leads to very minimal expenditure switching, for example in situations where there are no
domestic substitutes for imported goods as the case is in most LDCs, devaluation may worsen the

deficit. Under the floating exchange rate regime however, BoP equilibrium is attained without
intervention in the exchange rate movements.
The elasticity approach, therefore, considers the responsiveness of imports and exports to changes
in the national currency. For example, if the import demand is highly elastic, a devaluation or
depreciation of a country's currency is expected to cause a substantial decline in imports. However,
in reality, devaluation may take time to work since exports have inelastic supply, especially in the
LDCs due to the nature of exports from these countries and external factors such as unfavourable
terms of trade. Indeed, one might expect very little to happen to the volume of exports and imports
demanded initially as consumers take time to shift from consumption of imported to domestically
produced goods. Moreover, there is limited scope for switching from imports to domestic
substitutes in most in LDCs. Foreign consumers may also take time to adjust from domestic goods
to foreign exports. If this is the case, the BoP may actually worsen soon after devaluation, before
improving at a later stage. Therefore, the elasticity approach poses two problems for economic
analysis;
the conditions required to switch expenditure in the desired direction, and the source of the
additional output required to meet the increased demand for import substitutes. However, a rise in
the prices of import substitutes and exports will induce domestic producers to shift production from
non-tradable to tradable, and a shift in the labour market as well.
With the passage of time, the quantity of exports rises and the quantity of imports falls, so that the
initial deterioration in a country's trade balance begins to reverse.

Economists have called this tendency of a country's trade balance to first deteriorate before
improving as a result of a devaluation of a country's currency, the J-curve effect" (Salvatore,
1998:521). The explanation is that when a country's trade balance is plotted on the vertical axis, the
response of the trade balance to a devaluation looks like letter J. This is demonstrated in Figure 2.1
below:

The diagram above demonstrates that from the origin and a given trade balance, a devaluation of the
domestic currency will first result in a deterioration of the trade balance before an improvement is

attained. Hence, even if the Marshall-Lerner condition is met, the current account may worsen in
the short-run before improving in the longer term, as noted in the outgoing discussion. However, it
should be noted that the J-curve effect is (an often, but not always) observed phenomenon.
The Absorption Approach
This approach is based on the Keynesian school of thinking and holds the view that the BoP is
linked to changes in real domestic income (Choonaratana, 1989:29). Johnson also explains the
essence of this approach as "a relation between the aggregate receipts and expenditures of the
economy, rather than as a relation between the country's credits and debits on international

account"(Johnson, 1976:47). Its formal development is credited to Alexander (1952) who named it
Absorption Approach, though many others contributed . He began with the identity that production
or income (Y) is equal to consumption (C) plus domestic investment (I) plus the trade balance (XM), all in real in terms as an extension of the Keynesian Income/Output model.
That is;

(X-M)

(2.1)

But then letting A equal domestic absorption, (C+I) and B equal the trade balance, (X- M) in
equation (2.1) yields;
Y = A + B, (2.2)
By subtracting A from both sides of (2.2), we get;
Y-A=B

(2.3)

That is, domestic production/income minus absorption equals the trade balance. The formulation
also suggests that policies for correcting a trade imbalance can be broadly classified into two
categories; those aimed at increasing production (output- increasing), and those which aim at
reducing expenditure/absorption (expenditure- reducing). However, if a nation is at full
employment, production or real income (Y) cannot rise and devaluation can only be effective if
domestic absorption (A) falls, either automatically or as a result of contractionary fiscal and
monetary policies (Salvatore, 1998:559). In other words, a current account deficit is reduced
through the implementation of policies that reduce aggregate demand. However, LDCs normally
have unemployed resources available, the additional output required to meet the increased demand
could be provided by the re-absorption of these resources into employment. Under such
circumstances, expenditure switching could increase employment and income. ]n this regard, the
elasticity and absorption approaches are important and can be considered simultaneously.
A devaluation of the exchange rate can affect the foreign balance (B), in two ways. Firstly; it can
lead to a change in income (Y), which in turn induces a change in absorption (A). To this end, a
change in the foreign balance will be composed of changes in both income and absorption.
Secondly, a devaluation may change absorption for any given level of real income. Thus, while the
elasticity approach stresses the demand side and implicitly assumes that the economy adjusts to
satisfy the additional demand for exports and imports substitutes, the absorption approach stresses
the supply side and implicitly assumes adequate demand for the country's exports and import
substitutes.

The Monetary Approach to the Balance of Payments (MABP)

Development of the Monetary Approach
The MABP has "a long, solid, and academically overwhelmingly reputable history" (Frenkel and
Johnson (1976:29). It is one of the approaches that were developed in the 1950s and the early 1970s
with a view of understanding the sequences of economic events that lead countries into BoP
problems and the policy measures that could prevent or correct such distortions. These changes
reflected the dissatisfaction with the macroeconomic management, which was still dominated by the
Keynesian thinking and its explanation of the economic problems. Many advocates of the MABP
associate its roots to David Hume (1752), see Frenkel and Johnson, 1976:147-148. However, its
modern form is linked to economists from the Research Department of the IMF, University of
Chicago, and the London School of Economics. The list includes Mundell, Johnson, Polak, Frenkel,
Mussa, and Dornbusch among others. Some of the key factors that contributed to renewed interest
in the area of BoP adjustments were the policy challenges that were encountered by policy makers.
Rhomberg and Heller, (1977:6) note that the initial impetus towards research in this area came from
the IMF staff's work on problems of LDCs, which at the time lacked the detailed national accounts
data required to analyse the BoP problem using the absorption and elasticity approaches. However,
since monetary and payments statistics were available in most countries, there was a need to
develop a framework that could utilise this database. In addition, there was a need to develop a
quantitative framework that would be manageable during staff missions during the period before
wide access to computers. Therefore, the monetary approach was particularly considered
appropriate in this respect.

The Theoretical Framework of the Monetary Approach

The task of this section is to examine the theoretical framework of the MABP. It attempts to explore
the theoretical propositions and assumptions on which the approach is based. The modern
theoretical foundation of the monetary approach is traced back to the work of Mundell (1968, 1971)
at the University of Chicago, Johnson, and other economists who have been working along similar
lines. The MABP views the BoP as an essentially monetary phenomenon (Frenkel and Johnson,
1976:21). "Payments adjustment is viewed in terms of monetary adjustment instead of relative price
and income changes", (Buzakuk, 1988:52). In other words, the MABP stresses the importance of
monetary variables in explaining the changes in the BoP. The term "balance of payments" as a
starting point is implicitly defined by MABP theorists as a set of items that are "below the line" in
the overall balance of payments. These items in principle constitute the "money account".
Essentially, the MABP is a supply and demand analysis of the money market in an open economy
(Taylor, 1990:32). Thus, any excess demand or supply of money is exactly reflected in the
movements in BoP. Accordingly, surpluses in the trade account and the capital account respectively
reflect excess flows of goods and securities, while a surplus in the money account represents an
excess domestic flow of demand for money. Consequently, when analysing the rate of increase or
decrease in a country's foreign reserves, the MABP focuses on the determinants of the excess
domestic t10w demand or supply of money, where supply is believed to bc composed of
international reserves and domestic credit. Taylor (1990) observes that a BoP surplus emerges, if the
domestic component of the monetary base is not adjusted in a situation where the demand for
money exceeds its actual stock. In this case, money will be sucked into through the external account
as individuals attempt to increase their money balances.
In the simplest empirical formulation of the MABP, most expositions assume a small open
economy, in which a stable demand for money balances is determined by the price level, real
income, and interest rate, while the supply of money equals the money multiplier times high
powered money (reserves plus domestic credit). In short,
Money demand, Md = L(p, y, r)
Money supply,
so that in equilibrium,

Ms = meR + D)
(Md = Ms); L(p, y, r)meR + D)

Where, p - price level, y - real income, r - interest rate, m - multiplier, R - reserves and D - domestic
credit, (see Taylor, 1990:33). This formulation is based on the flow equilibrium condition for the
money market (Johnson, 1972). The basic message of the MABP as Taylor observed is that, the
domestic credit level should be high enough to satisfy the demand for the domestic money stock, to

avoid payments disequilibria. Similarly, the MABP considers a deficit in the BoP as a consequence
of an excess in the domestic money stock over what is required in the economy. A variation in the
supply of money relative to its demand is associated with payments problems. Therefore, in the
event of a monetary disturbance, the MABP states that the international reserves component will
carry the burden of equating the demand for and supply of money. However, it should be noted that
authorities can influence the domestic composition of the money stock, particularly under the fixed
exchange rate regime. Under the flexible exchange rate system, attention is shifted from the BoP
(which is always zero), to changes in the exchange rate, which moves up and down to
absorb the consequences of policy and other changes, which would afTect the BoP under a fixed
exchange rate system (Mussa, 1976:189). On the other hand, under a managed float system as in the
case of Uganda, monetary authorities can intervene in the foreign exchange market to moderate the
movements in the exchange rate. Thus, under a managed float, the adjustment in official reserves is
usually proportional to the degree of intervention in the foreign exchange market to influence the
level and movement of exchange rate not, the BoP deficit.
The Adjustment Mechanism
In an open economy, the BoP plays an important role in determining changes in the stock of
domestic money and it is viewed as part of the adjustment mechanism that works to restore
equilibrium in the money market (Buzakuk, 1988:57). According to the MABP, the adjustment
works in such a way that when an economy is initially in equilibrium, and runs a current account
deficit, it would mean that the country has excess demand for goods and serVIces or national
investment exceeds national savings. Normally, external resources or increased domestic savings
can finance this gap. On the other hand, a deficit in the capital account is an indication' of an excess
demand in the country's bond markets, which could be satisfied by importing more securities into
the country than what is being sold to the outside world. While according to Walras' law , if country
runs a deficit on the overall balance, it must
have an excess supply in the money market. The MABP views the BoP disequilibrim as a
mechanism by which an excess supply of (demand for) money is removed from the domestic
market. For instance, increases in the level of domestic credit result into growth in the money
supply and distort the monetary equilibrium. In order to restore equilibrium in the money market,
the public needs to dispose of the excess quantity of money over time by buying foreign goods. The
direct effect of such an action is a BoP deficit and running down the country's foreign reserves. The
loss of reserves reduces the quantity of money and eliminates the excess supply over time.
Therefore, when an exogenous shock occurs, particularly under a fixed exchange rate regime, the

adjustment process begins and keeps working until the excess supply of (demand for) money
disappears and equilibrium is restored. At that point, the flow demand for goods and bonds match
their flow supplies and the economy achieves equilibrium and payments balance (Buzakuk,
1988:59). Therefore, the monetary authorities need to monitor domestic credit creation to prevent a
surge in money supply in the economy.
It should however be noted that the nature of adjustment greatly depends on the type of exchange
rate regime in a particular country. In a fixed exchange rate system, adjustment is through changes
in the BoP, whereas in a flexible exchange rate system, equilibrium in the money market is restored
through movements in the exchange rate. In the case of a managed t10at, the authorities usually
intervene in the market using official reserves and the change in reserves is proportional to the
degree of intervention in the foreign exchange market. Further expositions can be found in the work
edited by Frenkel and Johnson, 1976, and Mundell, 1968.

The Structural Approach to the Balance of Payments

Origin
This approach to the Balance of Payments arose from a consideration of developing countries, but
has also been applied to developed countries.
Principal Elements
1. Distrust in the operation of markets. Balance of payments imbalances often arise from structural
imbalances within the economy which arise because growth and development involve
continuous processes of structural change.
These may lead to:
(a) different regions growing at different speeds e.g. in the UK, the Southeast growing faster than
the Northeast. High income in the Southeast leads to increased demand for imports, which cannot
be produced in the Northeast. The lack of mobility of labour ensures that the imbalance remains.

(b) different sectors growing at different speeds, causing supply bottlenecks e.g. in developing
economies, urban sectors may grow rapidly, but agricultural sectors may be unable to adjust rapidly,
leading to the increased import of food.

(c) changing patterns of demand. Countries may be unable to shift resources away from products
that are no longer competitive internationally into new products for which prospects appear brighter.
That is, imbalance is caused by the structural characteristics of goods on the supply side of the
market. Adjustment through changing prices (including through exchange rate variations) may be
slow and ineffective in eliminating the disequilibrium. Thus, both traditional Keynesian and
monetarist policies will be ineffective in overcoming balance of payments problems.
2. Stress is placed, therefore, on the characteristics of imports and exports. Particular problems will
arise where:
(a) a country's exports are income-inelastic: as world income rises, the demand for exports does not
keep pace (old heavy industries: shipbuilding etc);
(b) its imports are income-elastic: growth leads directly to balance of payments deficits (essential
raw materials, foreign-produced consumer goods, energy sources).
3. It follows that the country's goods are non-competitive on non-price grounds. The elasticities and
other approaches are generally concerned with price-competitiveness. Here, rather, the stress is on
quality, delivery dates, after-sales service etc. Depreciation of the exchange rate, thus improving
price-competitiveness, will only be of temporary assistance. The long-run decline continues because
of non-price competitiveness. This is often due to inadequate investment and/or inadequate training
of the work-force.

These problems are often circular. For example, a structural problem arises leading to a balance of
payments deficit. Traditional expenditure-switching or expenditure-reducing policies are followed.
In the first case, depreciation leads to domestic inflation, which rapidly erodes any improvement in
price competitiveness. In the second case, expenditure reduction may be achieved:
(a) through increases in interest rate, but these lead to lower investment and industry becomes less
competitive on non-price grounds; or
(b) through lower government expenditure or higher tax rates but lower government expenditure
may lead to a deteriorating infrastructure again reducing non-price competitiveness. However
reduced income is achieved, it will be associated with higher unemployment and this may lead to
lack of confidence in the economy and again to lower investment. Consider, alternatively, a
developing country case:

Worsening agricultural terms of trade leads to a balance of payments deficit, which in turn leads to a
shortage of foreign exchange. This means the lack of ability to buy imported capital equipment
necessary to diversify into other industries or to increase the productivity of already existing
industries.
All this means that growth may induce balance of payments problems and that such problems may
act as a constraint on further growth. Within developed countries, Balance of Payment constrained
growth may lead to deindustrialization and the shrinking of the countrys manufacturing base.
The Structural Approach and Economic Policy
The situation requires:
(a) government intervention: government investment in order to improve non-price competitiveness
and to foster a switch from exports with low income-elasticities to industries with high incomeelasticities;
(b) selected import controls to protect industries while they improve non-price competitiveness;
(c) possibly exchange controls to help ration scarce foreign exchange.
Criticisms of the approach include:
(a) it adopts too pessimistic a view of the ability of a developing country to switch resources to the
export sector in line with changes in comparative advantage;
(b) it underestimates the extent to which resources can be transferred through the price mechanism;
(c) assumptions about the possibilities of substitution between domestic and foreign inputs may be
too rigid.

The Analytical Framework showing some of the possible linkages

between domestic credit and the BoP:

There are two possible links. Link A suggests that domestic credit expansion boosts production and
increases domestic output. Higher production creates demand for more inputs including imported
materials. As the volume of imports expands, the BoP tends to experience imbalances on the current
account. Therefore, if other things are constant, high economic growth tends to give rise to a deficit
in the BoP.
In link B, if domestic credit expands faster than what the economy can absorb, it leads to
autonomous increases in money supply - reflected in an excess demand for goods and services. The
excess demand in turn pushes domestic prices upwards. Consequently, the increase in money supply
generates higher spending in the economy and worsens the external balance. Also, if the income
elasticity of import demand is high, it tends to create excess demand for foreign exchange and
depreciation of the exchange rate. However, a rise in the exchange rate (depreciation) may be
positive for the BoP as it improves the competitiveness of the country's exports. The opposite is true
for an appreciation.
In summary, growth in domestic output is expected to lead to a deterioration of the BoP (mainly the
trade balance), since it increases demand for goods and services, particularly imports. Also,
excessive credit expansion leads to payments imbalances as the residents dispose of the extra
money by spending it on goods and services. On the other hand, as the economy grows, the demand
for money increases, arid if there is no autonomous increase in money supply, a BoP surplus will be
observed as the additional money is fed into the economy.

3
3.1 STRUCTURE OF BALANCE OF PAYMENTS
The Balance of Payment (BOP) of a country is a systematic account of all economic transactions
between a country and the rest of the world, undertaken during a specific period of time. BOP is the
difference between all receipts from foreign countries and all payments to foreign countries. If the
receipts exceed payments, then a country is said to have favourable BOP, and vice versa.

According to Charles Kindle Berger "The BOP of a country is a sy

Receipts (Credits)

Payments (Debits)

1. Export of goods.

Imports of goods.

Trade Account Balance

2.

Export of services.

Import of services.

3.

Interest, profit and dividends

Interest, profit and dividends paid.

received.
4. Unilateral receipts.

Unilateral payments.

Current Account Balance (1 to 4)

5. Foreign investments.

Investments abroad.

6. Short term borrowings.

Short term lending.

7. Medium and long term borrowing.

Medium and long term lending.

Capital Account Balance (5 to 7)

Errors and omissions.
8. Errors and omissions.
9. Change in reserves. (+)
Total Reciepts

Change in reserve (-)

Total Payments

Total payments.

stematic recording of all economic transactions between residents of that country and the rest of
the world during a given period of time".The Balance of payments record is maintained in a
standard double - entry book - keeping method. International transactions enter into record as credit
or debit. The payments received from foreign countries enter as credit and payments made to other
countries as debit. The following table shows the elements of BOP.

BALANCE OF PAYMENTS ACCOUNT

1.

Trade Balance :Trade balance is the difference between export and import of goods, usually referred as

visible or tangible items. If the exports are more than imports, there will be trade surplus and if

imports are more than exports, there will be trade deficit. Developing countries have most of the
time suffered a deficit in their balance of payments. The trade balance forms a part of current
account. In 2008-09, trade deficit of India was 118.6 US $ billion.
2.

Current Account Balance :It is the difference between the receipts and payments on account of current account which

includes trade balance. The current account includes export of services, interest, profits, dividends
and unilateral receipts from abroad and the import of services, profits, interest, dividends and
unilateral payments abroad. There can be either surplus or deficit in current account. When debits
are more than credits or when payments are more than receipts deficit takes place. Current account
surplus will take place when credits are more and debits are less.
Current account balance is very significant. It shows a country's earning and payments in
foreign exchange. A surplus balance strengthens the country's international financial position. It
could be used for development of the country. A deficit is a problem for any country but it creates a
serious situation for developing countries. In 2009-10 Indias current account deficit was 38.4 US $
billion.
3.

Capital Account Balance :It is the difference between receipts and payments on account of capital account. The

transactions under this title involves inflows and outflows relating to investments, short term
borrowingsI lending, and medium term to long term borrowings / lending. There can be surplus or
deficit in capital account. When credits are more than debits surplus will take place and when debits
are more than credits deficit will take place. In 2009-10. Indias capital account surplus was 51.8 US
$ billion.
4.

Errors and Omissions :The double entry book - keeping principle states that for every credit, there is a

corresponding debit and therefore, there should be a balance in BOP as well. In reality BOP may
not balance, due to errors and omissions. Errors may be due to statistical discrepancies (differences)
and omissions may be due to certain transactions may not get recorded. For Eg., remittance by an
Indian working abroad to India may not get recorded etc. If the current and capital account shows a
surplus of 20,000 $, then the BOP should show an increase of 20,000 $. But, if the statement shows
an increase of 22,000 $, then there is an error or omission of 2,000 $ on credit side.
5.

Foreign Exchange Reserves :-

The balance of foreign exchange reserve is the combined effect of current and capital
account balances. The reserves will increase when:a) The surplus capital account is much more than the deficit in current account.
b) The surplus in current account is much more than deficit in capital account.
c) Both the current account and capital account shows a surplus.
In 2009-10 Indias foreign exchange reserves increased by 13.4 US $ billion.

3.2EQUILIBRIUM AND DISEQUILIBRIUM IN BOP

Balance of payments is the difference between the receipts from and payments to foreigners
by residents of a country. In accounting sense balance of payments, must always balance. Debits
must be equal to credits. So, there will be equilibrium in balance of payments.
Symbolically, B = R - P
Where : - B = Balance of Payments
R = Receipts from Foreigners
P = Payments made to Foreigners
When B = Zero, there is said to be equilibrium in balance of payments.
When B is positive there is favourable balance of payments; When &. B is negative there is
unfavourable or adverse balance of payments.' When there is a surplus or a deficit in balance of
payments there is said : to be disequilibrium in balance of payments. Thus disequilibrium refers to
imbalance in balance of payments.
Meaning

of

Disequilibrium

in

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.
Disequilibrium of Deficit arises when our receipts from the foreigners fall below our payment to
foreigners. It arises when the effective demand for foreign exchange of the country exceeds its
supply at a given rate of exchange. This is called an 'unfavourable balance'.

Disequilibrium of Surplus arises when the receipts of the country exceed its payments. Such a
situation arises when the effective demand for foreign exchange is less than its supply. Such a
surplus disequilibrium is termed as 'favourable balance.

3.3TYPES OF DISEQUILIBRIUM IN BOP

The following are the main types of disequilibrium in the balance of payments:1.

Structural Diseguilibrium :Structural disequilibrium is caused by structural changes in the economy affecting demand

and supply relations in commodity and factor markets. Some of the structural disequilibrium are as
follows :a.

A shift in demand due to changes in tastes, fashions, income etc. would

decrease or increase the demand for imported goods thereby causing a

disequilibrium in BOP.
b.

If foreign demand for a country's products declines due to new and cheaper substitutes
abroad, then the country's exports will decline causing a deficit.

c.

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

d.

If supply is affected due to crop failure, shortage of raw-materials, strikes, political

instability
e.

etc., then there would be deficit in BOP.

A war or natural calamities also result in structural changes which may affect not only goods
but also factors of production causing disequilibrium in BOP.

f.

Institutional changes that take place within and outside the country may result in BOP

disequilibrium. For Eg. if a trading block imposes additional import duties on products imported in
member countries of the block, then the exports of exporting country would be restricted or
reduced. This may worsen the BOP position of exporting country.

2.

Cyclical Disequilibrium :Economic activities are subject to business cycles, which normally have four phases Boom

or Prosperity, Recession, Depression and Recovery. During boom period, imports may increase

considerably due to increase in demand for imported goods. During recession and depression,
imports may be reduced due to fall in demand on account of reduced income. During recession
exports may increase due to fall in prices. During boom period, a country may face deficit in BOP
on account of increased imports.
Cyclical disequilibrium in BOP may occur because
a. Trade cycles follow different paths and patterns in different countries.
b. Income elasticities of demand for imports in different countries are not identical.
c. Price elasticities of demand for imports differ in different countries.
3.

Short - Run Disequilibrium :This disequilibrium occurs for a short period of one or two years. Such BOP disequilibrium

is temporary in nature. Short - run disequilibrium arises due to unexpected contingencies like failure
of rains or favourable monsoons, strikes, industrial peace or unrest etc. Imports may increase
exports or exports may increase imports in a year due to these reasons and causes a temporary
disequilibrium exists.
International borrowing or lending for a short - period would cause short - run
disequilibrium in balance of payments of a country. Short term disequilibrium can be corrected
through short - term borrowings. If short - run disequilibrium occurs repeatedly it may pave way for
long - run disequilibrium.

4.

Long - Run I Secular Disequilibrium :Long run or fundamental disequilibrium refers to a persistent deficit or a surplus in the

balance of payments of a country. It is also known as secular disequilibrium. The causes of long term disequilibrium are
a. Continuous increase in demand for imports due to increasing population.
b. Constant price changes - mostly inflation which affects exports on continuous basis.
c. Decline in demand for exports due to technological improvements in importing countries, and as
such the importing countries depend less on imports.

The long run disequilibrium can be corrected by making constant efforts to increase exports
and to reduce imports.
5.

Monetary Diseguilibrium
Monetary disequilibrium takes place on account of inflation or deflation. Due to inflation,

prices of products in domestic market rises, which makes exports expensive. Such a situation may
affect BOP equilibrium. Inflation also results in increase in money income with people, which in
turn may increase demand for imported goods. As a result imports may turn BOP position in
disequilibrium.
6.

Exchange Rate Fluctuations :A high degree of fluctuation in exchange rate may affect the BOP position. For Eg. if

Indian Rupee gets appreciated against dollar, then Indian exporters will receive lower amounts of
foreign exchange, whereas, there will be more outflow of foreign exchange on account of higher
imports. Such a situation will adversely affect BOP position. But, if domestic currency depreciates
against foreign currency, then the BOP position may have positive impact.

4
4.1 CAUSES OF DISEQUILIBRIUM IN B O P

Any disequilibrium in the balance of payment is the result of imbalance between receipts and
payments for imports and exports. Normally, the term disequilibrium is interpreted from a negative
angle and therefore, it implies deficit in BOP.
The disequilibrium in BOP is caused due to various factors. Some of them are
I.

Import - Related Causes

The rise in imports has been the most important factor responsible for large BOP deficits.

The causes of rapid expansion of imports are :1.

Population Growth
Population Growth may increase the demand for imported goods such as food items and

non food items, to meet their growing needs. Thus, increase in imports may lead to BOP
disequilibrium.

2.

Development Programme
Increase in development programmes by developing countries may require import of

capital goods, raw materials and technology. As development is a continuous process, imports of
these items continue for a long time landing the developing countries in BOP deficit.
3.

Imports Of Essential Items

Countries which do not have enough supply of essential items like Crude oil or Capital

equipments are required to import them. Again due to natural calamities government may resort to
heavy imports, which adversely affect the BOP position.
4.

Reduction Of Import Duties

When import duties are reduced, imports becomes cheaper as such imports increases. This

increases the deficit in BOP position.

5.

Inflation
Inflation in domestic markets may increase the demand for imported goods, provided the

imported goods are available at lower prices than in domestic markets.

6.

Demonstration Effect
An increase in income coupled with awareness of higher living standard of foreigners,

induce people at home to imitate the foreigners. Thus, when people become victims of
demonstration effect, their propensity to import increases.

II.

Export Related Causes :Even though export earnings have increased but they have not been sufficient enough to

meet the rising imports. Exports may reduce without a corresponding decline in imports. Following
are the causes for decrease in exports
1.

Increase In Population :Goods which were earlier exported may be consumed by rising population. This reduces

the export earnings of the country leading to BOP disequilibrium.

2.

Inflation :When there is inflation in domestic market, prices of export goods increases. This reduces

the demand of export goods which in turn results in trade deficit.

3.

Appreciation Of Currency :Appreciation of domestic currency against foreign currencies results in lower foreign

exchange to exporters. This demotivates the exporters.

4.

Discovery Of Substitutes :With technological development new substitutes have come up. Like plastic for rubber,

synthetic fibre for cotton etc. This may reduce the demand for raw material requirement.
5.

Technological Development :Technological Development in importing countries may reduce their imports. This can be

possible when they start manufacturing goods which they were exporting earlier. This will have an
adverse effect on exporting countries.
6.

Protectionist Trade Policy :Protectionist trade policy of importing country would encourage domestic producers by

giving them incentives, whereas, the imports would be discouraged by imposing high duties. This
will affect exports.
III.
1.

Other Causes :Flight of Capital

Due to speculative reasons, countries may lose foreign exchange or gold stocks. Investors

may also withdraw their investments, which in turn puts pressure on foreign exchange reserves.
2.

Globalisation
Globalisation and the rules of WTO have brought a liberal and open environment in global

trade. It has positive as well as negative effects on imports, exports and investments. Poor countries
are unable to cope up with this new environment. Ultimately they become loser and their BOP is
adversely affected.
3.

Cyclical Transmission
International trade is also affected by Business cycles. Recession or depression in one or

more developed countries may affect the rest of the world. The negative effects of trade cycle (low
income, low demand, etc.) are transmitted from one country to another. For eg. The current
financial crisis in U.S.A. is affecting the rest of the world.
4.

Structural Adjustments
Many countries in recent years are undergoing structural changes. Their economies are

being liberalised. As a result, investment, income and other variables are changing resulting in
changes in exports and imports.

5.

Political factors
The existence of political instability may result in disrupting the productive apparatus of the

country causing a decline in exports and increase in imports. Likewise, payment of war expenses
may also serious affect disequilibrium in the countrys BOP. Thus political factors may also produce
serious disequilibrium in the countrys BOPs.

3.2Methods of correcting disequilibrium in the balance of

payments
There are several methods to correct balance of payment disequilibrium. The methods depend on
the nature and causes of disequilibrium.
The methods can be classified into two groups: viz. monetary and non monetary methods

Monetary methods
Monetary methods of correction affect the balance payments by changing the value or flow of
currencies; both domestic and foreign. Indirectly, it affects the volume and value of exports and
imports. With flexible exchange rate it is possible to affect the value and volume of exports and
imports.
Following are the various monetary methods of BOP correction:
1.

Devaluation

Devaluation refers to deliberate try made by using monetary authorities to bring down the worth of
home foreign money towards foreign exchange. while depreciation is a spontaneous fall due to
interactions of market forces, devaluation is professional act enforced with the aid of the financial
authority. in most cases the international monetary fund advocates the coverage of devaluation as a
corrective measure of disequilibrium for the countries going through adversarial steadiness of fee
position. When Indias balance of fee worsened in 1991, IMF steered devaluation. for that reason,
the worth of Indian forex has been reduced with the aid of 18 to twenty% relating to quite a lot of
currencies. The 1991 devaluation introduced the specified impact. The very next yr the import
declined whereas exports picked up.

When devaluation is effected, the worth of house forex goes down in opposition to foreign currency,
let us believe the trade fee continues to be $1 = Rs. 10 before devaluation. let us suppose,
devaluation takes situation which reduces the worth of residence currency and now the exchange
price turns into $1 = Rs. 20. After this sort of exchange our items turns into cheap in overseas
market. it is because, after devaluation, dollar is exchanged for extra Indian currencies which push
up the demand for exports. at the same time, imports grow to be dearer as Indians need to pay more
currencies to obtain one buck. hence demand for imports is lowered.
Typically devaluation is resorted to where theres severe adverse steadiness of cost drawback.
Boundaries of Devaluation :1. Devaluation is successful simplest when different us of a does now not retaliate the identical. If
each the countries go for the same, the impact is nil.
2. Devaluation is successful most effective when the demand for exports and imports is elastic. In
case it is inelastic, it is going to flip the placement worse.

3. Devaluation, although helps correcting disequilibrium, is thought to be to be a weak point for

the usa.
4. Devaluation may bring inflation within the following prerequisites :1. Devaluation brings the imports down, When imports are diminished, the home supply of
such items need to be elevated to the identical extent. If no longer, shortage of such goods
unleash inflationary developments.
2. A rising usa like India is capital thirsty. due to non availability of capital items in India, we
have no option but to proceed imports at greater prices. this will force the industries
depending upon capital goods to push up their costs.
3. When demand for our export rises, increasingly goods produced in a country would go for
exports and thus developing scarcity of such items at the home stage. This ends up in
rising prices and inflation.
4. Devaluation is probably not effective if the deficit arises due to cyclical or structural
changes.
2.

Pegging Operations
Pegging down the value of currency is done by the Government. The Central

bank

depending on the need may artificially, increase or decrease the value of currency,

temporarily.
Pegging operations can be done any number of times. Since it is done by

the Government, it may be beneficial. It is reversible; it offers the Government the

flexibility to manage the value of the currency for its advantage.
Deflation
Deflation method falling costs. Deflation has been used as a measure to correct deficit
disequilibrium. a country faces deficit when its imports exceeds exports.
Deflation is introduced via financial measures like financial institution price coverage, open market
operations, etc or through fiscal measures like larger taxation, reduction in public expenditure, and
so forth. Deflation would make our objects more cost effective in international market resulting a
upward thrust in our exports. on the similar time the calls for for imports fall due to greater taxation
and reduced earnings. this is able to constructed a favourable environment within the steadiness of
fee position. then again Deflation can be a success when the exchange charge remains fixed.

Exchange Controls
1.

Deliberate management of exchange markets, value, and volumes of

currencies form the exchange controls. There are several methods of exchange controls
which can affect the value and flows of currencies for improving the BOP position.

2.

Exchange controls include methods like, pegging operations, multiple

exchange rates, mutual clearing agreements etc.

3.

It can be seen that, monetary methods of correcting BOP disequilibrium aim

at solving the crisis on capital account and directly managing flow of foreign exchange.
Indirectly, the value of currency can bring equilibrium on current account as well by
changing volume of exports and imports.

Non-financial Measures for Correcting the BoP

A deficit united states of america along with financial measures may undertake the following nonmonetary measures too so as to both prohibit imports or promote exports.
1. Tariffs
Tariffs are obligations (taxes) imposed on imports. When tariffs are imposed, the prices of imports
would raise to the extent of tariff. The elevated prices will reduced the demand for imported goods
and at the same time result in domestic producers to provide more of import substitutes. Non-very
important imports will also be significantly lowered by using imposing an extraordinarily excessive
fee of tariff.

Drawbacks of Tariffs :1. Tariffs deliver equilibrium through reducing the volume of exchange.
2. Tariffs impede the expansion of world exchange and prosperity.
3. Tariffs dont need to essentially cut back imports. hence the effects of tariff on the steadiness of
cost position are uncertain.
4. Tariffs are trying to find to establish equilibrium without disposing of the foundation causes of
disequilibrium.

5. a new or the next tariff may worsen the disequilibrium within the stability of payments of a
rustic already having a surplus.
6. Tariffs to be successful require an efficient & sincere administration which sadly is tough to
have in most of the international locations. Corruption among the many administrative group of
workers will render tariffs ineffective.
2. Quotas
Underneath the quota machine, the federal government may fix and permit the utmost amount or
price of a commodity to be imported all over a given length. with the aid of limiting imports during
the quota machine, the deficit is diminished and the stability of payments place is greater.
Sorts of Quotas :1. the tariff or custom quota,
2. the unilateral quota,
3. the bilateral quota,
4. the mixing quota, and
5. import licensing.

Deserves of Quotas :1. Quotas are more effective than tariffs as theyre certain.
2. theyre simple to enforce.
3. they are simpler even when demand is inelastic, as no imports are that you can imagine above
the quotas.
4. more versatile than tariffs as theyre topic to administrative resolution. Tariffs on the other hand
are topic to legislative sanction.
Demerits of Quotas :1. they arent lengthy-run answer as they dont tackle the real cause for disequilibrium.
2. below the WTO quotas are discouraged.
3. Implements of quotas is open invitation to corruption.
3. Export promoting
The federal government can undertake export advertising measures to proper disequilibrium in the
stability of payments. This includes substitutes, tax concessions to exporters, advertising facilities,

credit score and incentives to exporters, and so forth. The federal government might also assist to
advertise export through exhibition, change festivals; conducting advertising research & through
offering the required administrative and diplomatic assist to faucet the possible markets.
4. Import Substitution
A rustic may motel to import substitution to scale back the quantity of imports and make it selfreliant. Fiscal and financial measures could also be adopted to inspire industries producing import
substitutes. Industries which produce import substitutes require special consideration in the type of
quite a lot of concessions, which include tax concession, technical assistance, subsidies, providing
scarce inputs, etc. Non-monetary strategies are simpler than financial methods and are generally
acceptable in correcting an antagonistic steadiness of payments.
Drawbacks of Import Substitution :1. Such industries could lose the spirit of competitiveness.
2. home industries playing more than a few incentives will increase vested pursuits and ask for such
concessions all the time.
3. Deliberate merchandising of import replace industries go against the theory of comparative benefit.

Conclusion
In short, correction of disequilibrium calls for a judicious mix of the following methods:
.

a) Monetary and fiscal changes affecting income and price in the country;

b) Exchange rate adjustment, i.e., depreciation or appreciation of the home currency;

c) Trade restrictions, i.e., tariffs, quotas, etc.;

d) Capital Movements, i.e., borrowing or lending abroad.

No reliance can be placed on any single tool. There is room for more than one approach and for
more than one device. But the application of the tool depends on the nature of disequilibrium. There
are four types of disequilibrium, two in income (cyclical and secular) and two in prices or structural
(at the goods and factor level). It is more appropriate that the cyclical and secular disequilibria be
tackled by monetary and fiscal measures. In structural disequilibria, exchange rate adjustment plays
a greater role. Generally, trade restrictions should be avoided. Capital movements by time in shortrun disturbances and are needed to offset deep-seated forces in secular disequilibrium.
The main methods of desirable adjustments are, therefore, a monetary and fiscal policy which
directly affects income, and exchange depreciation which affects prices in the first instance. It can
also have income effect through price effects. Monetary and fiscal policies affect relative prices
also.

Bibliography
1) www.rbi.org.in
2) en.wikipedia.org/wiki/Balance_of_payments
3) http://kalyan-city.blogspot.com
4) www.economicshelp.org
5) www.preservearticles.com