1) a) Describe the factors affecting balance of payments with suitable

examples.
b) Discuss the methods of correcting disequilibrium in balance of
payments.

A) BALANCE OF PAYMENTS:
The balance of payments, also known as balance of international payments and
abbreviated BoP or BP, of a country is the record of all economic transactions
between the residents of the country and the rest of the world in a particular period.
The balance of payments (BOP) records all financial transactions made between
consumers, businesses and the government in one country with others.

The BOP figures tell us about how much is being spent by consumers and
firms on imported goods and services, and how successful firms have been in
exporting to other countries.
Inflows of foreign currency are counted as a positive entry (e.g. exports sold
overseas)
Outflows of foreign currency are counted as a negative entry (e.g. imported
goods and services)

THE BOP IS DIVIDED INTO THREE MAIN CATEGORIES:

The current account, the capital account and the financial account. Within these
three categories are sub-divisions, each of which accounts for a different type of
international monetary transaction.
The balance of payments is made up of these key parts
i) The current account
ii) The capital account
iii) Official financing account
i) The Current Account
The current account is used to mark the inflow and outflow of goods and services
into a country. Earnings on investments, both public and private, are also put into
the current account.
Goods such as raw materials and manufactured goods that are bought, sold or
given away
Services refer to receipts from tourism, transportation (like the levy that must be
paid in Egypt when a ship passes through the Suez Canal), engineering, business
service fees and royalties from patents and copyrights.
Receipts from income-generating assets such as stocks (in the form of dividends)
are also recorded in the current account.

The last component of the current account is unilateral transfers. These are
credits that are mostly worker's remittances, which are salaries sent back into the
home country of a national working abroad, as well as foreign aid that is directly
received.
ii) The Capital Account:
The capital account is where all international capital transfers are recorded. This
refers to the acquisition or disposal of non-financial assets (for example, a physical
asset such as land) and non-produced assets, which are needed for production but
have not been produced, like a mine used for the extraction of diamonds.
The capital account is broken down into the monetary flows branching from debt
forgiveness, the transfer of goods, and financial assets by migrants leaving or
entering a country, the transfer of ownership on fixed assets (assets such as
equipment used in the production process to generate income), the transfer of
funds received to the sale or acquisition of fixed assets, gift and inheritance taxes,
death levies and, finally, uninsured damage to fixed assets.
iii) The Financial Account
In the financial account, international monetary flows related to investment in
business, real estate, bonds and stocks are documented. Also included are
government-owned assets such as foreign reserves, gold, special drawing rights
(SDRs) held with the International Monetary Fund (IMF), private assets held abroad
and direct foreign investment. Assets owned by foreigners, private and official, are
also recorded in the financial account.
Source: http://www.investopedia.com/articles/03/060403.asp

Source : http://www.tutor2u.net/economics/reference/balance-of-payments-1
Key point:
If a country is running a current account surplus, this means there is a net inflow of
foreign currency into their economic system. From a balance of payments point of
view, a surplus on the current account would allow a deficit to be run on the capital
account. For example, surplus foreign currency can be used to fund investment in
assets located overseas. The balance of payments must balance.
Countries with current account deficits can run into difficulties. If the deficit is large
and the economy is not able to attract enough inflows of foreign investment, then
their currency reserves will dwindle and there may come a point when the country
needs to seek emergency borrowing from institutions such as the International

Monetary Fund. Trade deficits and the resulting borrowing lead to a rise in
external debt.
HOW IT IS DIFFERENCE BETWEEN BALANCE OF TRADE
BALANCE OF PAYMENTS
Balance of payments is the overall
record of all economic transactions of a
country with the rest of the world.
On the other hand, balance of
payments includes
- Imports and exports of goods.
- Imports and exports of services.
- Capital transfers.
BoP is important than balance of trade
because BoP offers a comprehensive
picture of the country's economic
status.

BALANCE OF TRADE
Balance of trade is the difference in the
value of exports and imports of only
visible items.
Balance of trade includes imports and
exports of goods alone i.e., visible
items.

Balance of trade of a country can be

favorable or unfavorable but BoP
always balances.
If a country has a balance of trade
deficit, it imports more than it exports,
and
if it has a balance of trade surplus, it
exports more than it imports.

B) METHODS TO CORRECT BALANCE OF PAYMENTS:

There are several methods to correct BOP disequilibrium. The methods
can be classified in to two groups:
1. MONETARY METHODS: Monetary methods of correction effect the BOP by
changing the value or flow of currencies both domestic and foreign. Following are
the monetary methods:
(a) Deflation: Deflation means a reduction in the quantity of money so as to
bring about a fall in the prices and the money income of the people .Falling prices
encourage exports and discourage imports .Hence deflationary policy restores
equilibrium in BOP.
Deflation is not considered as a suitable method of correcting adverse BOP because
it reduces income and causes unemployment in the country
(b) Devaluation: It means decreasing the value of domestic currency in respect
of a foreign currency. Devaluation is done by the government of the country which
has unfavorable BOP. It is done deliberately to get its advantages. The government
officially declares devaluation indicating the extent of decrease in the value of
currency. Specific currency will be determined with which it is devalued. Devaluation
is irreversible. The country cannot change the value of currency frequently.

With a decrease in the value of its currency the country has to pay more in
exchange for a foreign currency. In this case the export becomes cheaper at the
same time import becomes expensive. With this export increases and import
decreases. However the success of devaluation depends on the following:
(i) The elasticity of demand for the countrys export should be high.
(ii) The elasticity of demand for countrys import should be fairly elastic
Devaluation as a method of correcting adverse BOP suffers from the
following defects:
(i) It reduces the public confidence in countrys currency as it is an indicator
of countrys weakness.
(ii) It increases the burden of public debt
(iii) It encourages inflationary tendencies in the home country.
(c) Exchange Depreciation: Depreciation refers to decline in the rate of
exchange of one currency in terms of other currency. It is similar to devaluation but
not done by the government. It is done in the exchange market with the help of
demand and supply of the currency. It takes place in a flexible exchange rate
system. It is automatic and can correct the adverse BOP of the country. But method
of exchange depreciation suffers from following defects:
(i) It is not suitable for a country which has adopted a fixed exchange rate
system
(ii) It makes international trade risky and thus reduces the volume of trade.
(iii) The terms of trade go against the country whose currency depreciates
(iv) Depreciation may generate inflationary pressure by making the
commodity more expensive.
(d) Exchange control: It is the most widely used method for correcting adverse
BOP. It refers to the control by the central bank over the use of foreign exchange. In
this method all the exporters are directed by the Central bank to surrender the
foreign exchange earnings and it is rationed out among the licensed importers, It
means only license holders can import goods.
Exchange control, does not remove the process of adverse BOP, It simply does not
allow the situation to worsen. Hence it is not considered a proper method to correct
adverse BOP.
(e) Capital movement: In flow of capital from the individuals and government of
other countries as well as borrowings from international financial institutions like
World bank, IMF etc. can be used to correct the deficit in BOP.
(f) Pegging operation: Pegging down the value. The central bank depending on
the need may artificially increase or decrease the value of currency temporarily.

Pegging operation can be done any no. of times. It is reversible. It offers the
flexibility to the government to manage the currency of value for its advantage.
2. NON MONETARY MEASURES: Non-monetary measures deal with the real sector
for correcting disequilibrium in BOP. Following are the important non-monetary
measures:
(a) Export promotion: To control adverse BOP the country may adopt export
promotion measures which are as follows:
(i) Cash assistance and subsidies can be given to exporters to increase export
(ii) Export duties may be reduced to encourage exports.
(iii) Goods meant for exports can be exempted from all types of taxes
(iv) Export oriented industries can be encouraged by providing better
infrastructure, better raw material, making favourable loan facilities etc.

(b) Import substitutes: The economy can develop technology of import

substitution. Industries producing import substitutes can be encouraged by capital
goods, better technology etc. Policy of import substitution can help the country to
become self-reliant.
(c) Import licensing: The government can have strong control over the exports
by having strict rules and regulations for providing licenses to importers
(d) Import quotas: Fixing import quotas may be a better device for correcting
the adverse BOP as they have the immediate effect of restricting imports .Import
quotas are important non-tariff barriers. They are positive restrictions on incoming
of goods.
(e) Tariff: It is a tax duty imposed on imports .The objective is to make imports
expensive .It reduces the demand for imports and the deficit in BOP gets corrected.
(f) Monetary policy: The central bank can reduce the volume of credit by raising
the bank rate, by selling securities in open market and by increasing cash reserve
ratio. This will make borrowing from commercial banks costlier .It will lead to fall in
investment and hence fall in income and employment and output. Any such
decrease in income decreases the demand for imports and disequilibrium in BOP
can be corrected.
(g) Fiscal policy: A restricted fiscal policy can also be used to wipe out BOP
deficit by reducing the total expenditure in the economy and increase in direct taxes
will reduce the disposable income and hence there will be reduction in demand for
imports. The decrease in government expenditure will also have the same effect on
decreasing the demand for imported goods.

Every country has to use the combination of monetary and non-monetary methods
to correct BOP disequilibrium and also prevent retaliation from any developed
country.
BALANCE OF PAYMENT MUST ALWAYS BALANCE:
In accounting sense BOP of a country is always in equilibrium. It is because of the
reason BOP is prepared in terms of credits and debits based on the system of
double entry book keeping. Under this system each transaction gives rise to two
equal entries. One credit entry and one debit entry. Thus total debits and total
credits must be equal. Similarly an international transaction generates two equal
entries and sum of all international receipts are equal to sum of international
payments. Surplus on current account can lead to the grant of loans to other
countries by the government or it can lead to increase in the countrys foreign
exchange reserve. Contrary to it a deficit on current account can be met by
borrowing from abroad or by running down countrys foreign exchange reserves.
Thus the two sides are necessarily balanced.