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BoP is a statistical statement that systematically summarizes, for a specific time period, the economic transactions of an economy with the rest of the world . IMF BoP Manual Simply stating, BoP refers to a systematic and summary record of a countrys economic and financial transaction with the rest of the world, over a period of time.
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Balance of Payments
Contd.
Balance of Payment components Capital account transactions Current account transactions Official reserves account Unilateral transactions
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Accounting Equilibrium
Since the Balance of Payments is constructed on the basis of double entry book keeping credit is always equal to debit. If debit on current account is greater than the credit, funds flow into the country that are recorded on the credit side of the capital account and the excess debit is wiped out. Thus the concept of Balance of Payment is based on the concept of accounting equilibrium, that is Current account + capital account = 0 The accounting balance is an expost concept. i.e., it describes what has actually happened over a specific period in the past.
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In economic sense, BoP of a country is said to be in equilibrium when the demand for foreign exchange is exactly equivalent to the supply of it. Balance of payments is regarded as being in disequilibrium when it shows either a surplus or a deficit. There will be a deficit in BoP when the demand for foreign exchange exceeds its supply, and there will be a surplus when the supply of foreign exchange exceeds the demand.
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BoP Disequilibrium
In the economic sense, a balance of payments equilibrium occurs when a surplus or deficit is eliminated from the balance of payments. But normally, such equilibrium is not found. Rather, it is disequilibrium in balance of payments that is a normal phenomenon. Economic factors Development disequilibrium Cyclical disequilibrium Secular disequilibrium Structural disequilibrium Political factors Sociological factors
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Contd.
capital inflow
capital account
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Elasticity Approach
After the collapse of the gold standard, the classical view could not remain tenable The adjustment in the balance of payments disequilibrium was thought of in terms of changes in the fixed exchange rate, that is , by devaluation or upward revaluation but its success dependent upon the elasticity of demand for export and import. Marshal & Lerner explained this phenomenon through the elasticity approach. This elasticity approach is based on the partial equilibrium analysis where everything is held constant except the effects of exchange rate changes on exports and imports.
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where X and M are exports and imports, ED, is elasticity of demand for exports, ES, is elasticity of supply for exports, EDm is elasticity of demand for imports, and ESm is elasticity of supply for imports.
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Absorption approach
The absorption approach is one of the earliest approaches representing the Keynesian view. Alexander (1959) treats balance of trade as a residual given by difference between what the economy produces and what it takes for domestic use or what it absorbs. He begins with the contention that the total output, Y is equal to the sum of consumption C, investment I, govt. spending G and net export (X-M). Mathematically, Y= C + I + G + ( X M ) Substituting C + I + G by absorption 'A, the above equation can be rewritten as Y=A or Y - A = X - M
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Absorption approach
Contd.
This means that the amount by which total output exceeds total spending or absorption, is represented by export over import or the net export which means a surplus balance of trade. This also means that. if A > Y, a deficit balance of trade will occur because excess absorption in absence of desired output will cause imports. Thus in order to bring about equilibrium in the balance of trade, the government has to increase output or income. Increase in income without corresponding and equal increase in absorption will lead to improvement in balance of trade. This is called the expenditure switching policy. In respect of full employment where resources are fully employed, output cannot be expanded and the balance of trade deficit can be remedied through decreasing absorption without a corresponding fall in output. This is known as the expenditure-reducing policy.
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Absorption approach
Contd.
On the contrary, where full employment is yet to be achieved, output can be increased and/or absorption can be reduced in order to bring about equilibrium in trade balance. It may be noted that the validity of the absorption approach depends upon the operation of the multiplier effect that is essential for accelerating output generation. It also depends on the marginal propensity to absorb that determines the rate of absorption, Black (1959) explains the absorption in a slightly different way. He ignores the governmental expenditure, G and equates X - M with S - I (where S is saving and I is investment.). He is of the opinion that when balance of trade is negative, the country has to increase saving on the one hand and reduce investment on the other. In case of full employment, he suggests the redistribution of national income in favour of profit earners who possess greater propensity to save.
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Absorption approach
Contd.
The impact of devaluation on the absorption can be explained broadly in three ways. First is the real balance effect. Costly imports in the sequel of devaluation raise the general price index. Under the assumption that the money stock does not change, the economic agents cut down the direct absorption in order to maintain their money balances. Second is the income distribution effect. A rise in the general price index in the wake of devaluation forces redistribution of income away from the fixed-income segment to the variable-income segment. Since the poor have a high propensity to absorb, the redistribution helps reduce the direct absorption.
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Absorption approach
Contd.
Third is the Laursen-Metzler (1950) effect. Devaluation leads to deterioration in terms of trade which in turn: 1. lowers the national income and thereby the income-related absorption; and 2. raises the consumption of domestically produced goods. While the former is the income effect, the tatter is the substitution effect. Absorption will be lower if the income effect is bigger than the substitution effect.
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Mundell-Fleming approach
Developed in the Keynesian framework, focuses through IS-LM curve on how the internal and external balance is influenced by fiscal and monetary policies. The IS curve for an open economy shows various combinations of output and interest rate. It shows: S+M=I+G+ X The left side of the equation is known as the leakages and the right side is known as the injections. Savings include autonomous savings plus savings on account of risen income based on marginal propensity to save. Imports include autonomous imports plus imports on account of risen income based on marginal propensity to import.
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Mundell-Fleming approach
Contd.
Investment is assumed to be an inverse function of rate of interest. Exports and governmental expenditure are autonomous with respect to interest rate and the level of national income. The relationship between leakages and income can be shown with an upward sloping line, whereas the injection schedule is downward sloping from left to right. The L-M schedule shows various combinations of level of income and rate of interest under the assumption that the supply of money is equal to demand for money meaning that the money market is in equilibrium. Money is demanded either for transaction purposes or for speculative purposes.
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Mundell-Fleming approach
Contd.
If income and imports increase and interest rate decrease following an expansionary monetary policy, balance of payments will turn deficit and BP schedule will shift leftward as in Figure 3.
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Monetary Approach
The monetarists believe that the balance of payments disequilibrium is a monetary and not structural phenomenon (Connolly, 1978). The adjustment is automatic unless the government is intentionally following an inflationary policy for quite a long period. Adjustment is brought about through making changes in monetary' variables.
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Monetary Approach
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Monetary Approach
Contd.
The process of adjustment varies among the types of exchange rate regime the country has opted for. In a fixed exchange rate regime or in gold standard, if the demand for money, that is the amount of money people with to hold is greater than the supply of money, the excess demand would be met through the inflow of money from abroad. On the contrary, with the supply of money being in excess of the demand for it, the excess supply is eliminated through the outflow of money to other countries. The inflow and the outflow influence the balance of payments. To explain it further, with constant prices and income and thus constant demand for money, any increase in domestic credit will lead to outflow of foreign exchange as the people will import more to lower the excessive cash balances.
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Monetary Approach
Contd.
As a result, the balance of payments will turn deficit. Conversely, a decrease in domestic credit would lead to an excess demand for money. International reserves will flow in to meet the excess demand. Balance of payments will improve. However, in a floating-rate regime, the demand for money is adjusted to the supply of money through changes in exchange rate. In a clean float, when the Central Bank makes no market intervention, the international reserves component of the monetary base remains unchanged. The balance of payments remains in equilibrium with neither surplus nor deficit. The spot exchange rate is determined by the quantity of money supplied and the quantity of money demanded.
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Monetary Approach
Contd.
When the Central Bank increases domestic credit through open market operations, supply of money is greater than the demand for it. The households increase their imports. With increased demand for imports, the domestic currency will depreciate and it will continue depreciating until supply of money equals the demand for money. Conversely, with decrease in domestic credit, the households reduce their import, Domestic currency will appreciate and it will continue appreciating until supply of money equals demand for money. In the case of managed floating, the Central Bank often intervenes to peg the rates at some desired level. And so this case is a mix of fixed and floating rate regimes. It means that changes in the monetary supply and demand influence not only the exchange rate but also the quantum of international reserves.
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Summary
Classical view: Self-adjusting process. Trade deficit outflow of gold decreased money supply lower prices higher exports elimination of trade deficit. Elasticity Approach (Marshall/ Lerner's view): Trade deficit devaluation (demand for export and import being price-elastic) exports cheaper abroad and higher export earnings + costlier imports and squeezed import bill elimination of trade deficit. Stern added the concept of supply elasticity meaning that supply elasticity for import and export must be favourable. Absorption Approach (Alexander's view): Trade deficit decrease in absorption (consumption + investment. + government expenditure) so that total output > absorption elimination of trade deficit.
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Summary Contd.
Black suggests for increasing saving and reducing investment, in order to , eliminate trade deficit. Mundell-Fleming view based on Adjustment in real income and nominal interest rate: Rise in interest rate lower income lower import elimination of trade deficit. Again, rise in interest rate inflow of foreign investment improvement in capital account to absorb trade deficit. New Cambridge School Approach: Greater taxes + lower governmental expenditure lower income lower import elimination of trade deficit.
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Summary Contd.
Monetary Approach: Fixed exchange rate: Reduction in credit creation decreased supply of money lower import falling trade deficit Floating exchange rate: Size of credit size of money supply exchange rate balance of trade.
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Conclusion
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