Balance of Payment

International Economics II (Econ 634)

(Undergraduate program- Economics)

Chapter 3: Balance of Payment

Mengesha Yayo(Ph.D.)

AAU, Department of Economics

March , 2022

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Contents

3.1. Definition and Purposes of Balance of Payments

3.2. Balance of Payments Accounting Principle
3.3. The Components of Balance of Payments
3.4. Balance of Trade and Balance of Payments
3.5. Balance of Payments Disequilibria
3.5.1. Balance of Payments Surpluses and Deficits
3.5.2. Financing Balance of Payments Deficit
3.5.3. Exchange Rates and the Balance of Payments
3.6. Approaches to Balance of Payments
3.6.1. Elasticity Approach to Balance of Payments
3.6.2. Absorption Approach to Balance of Payments
3.6.3. Monetary Approach to Balance of Payments
3.7. Summary and Conclusions

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Balance of Payments

Balance of Payments: Definition

The balance of payments is a statistical record of all the
economic transactions between residents of the reporting
country and residents of the rest of the world during a given
time period.
The usual reporting period for all the statistics included
in the accounts is a year.
However, some of the statistics that make up the balance
of payments are published on a more regular monthly and
quarterly basis.

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Balance of Payments

Without question the balance of payments is one of the most

important statistical statements for any country.
It reveals how many goods and services the country has been
exporting and importing, and whether the country has been
borrowing from or lending money to the rest of the world.
In addition, whether or not the central monetary authority
(usually the central bank) has added to or reduced its
reserves of foreign currency is reported in the statistics.

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Balance of Payments

A key definition that needs to be resolved at the outset is that of a

domestic and foreign resident.
It is important to note that citizenship and residency are not
necessarily the same thing from the view point of the
balance-of-payments statistics.
The term resident comprises busineses, individuals, households,
firms and the public authorities that make the country in
question their legal domicile.
Although a corporation is considered to be a resident of the
country in which it is incorporated, its overseas branch or
subsidiary is not.
There are some problems that arise with respect to the
definition of a resident.

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Balance of Payments

These problems with respect to Defintion of Resident :

Multinational corporations are by definition resident in more
than one country.
For the purposes of balance-of-payments reporting, the
subsidiaries of a multinational are treated as being
resident in the country in which they are located even if
their shares are actually owned by foreign residents.
Another problem concerns the treatment of international
organizations such as the International Monetary Fund, the
World Bank, United Nations and so forth.
These institutions are treated as being foreign residents
even though they reside in USA

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Balance of Payments

These problems with respect to Defintion of Resident :

Military personnel, government diplomats, tourists, and
workers who emigrate temporarily are considered residents of
the country in which they hold citizenship
Tourists are regarded as being foreign residents if they
stay in the reporting country for less than a year.
The criterion for a transaction to be included in the balance of
payments is that it must involve dealings between a resident of the
reporting country and a resident from the rest of the world.
Purchases and sales between residents of the same country are
excluded.

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Balance of Payments : Measurement

Double-Entry Accounting
The arrangement of international transactions into a
balance-of-payments account requires that each transaction be
entered as a credit or a debit.
A credit transaction is one that results in a receipt of a
payment from foreigners.
A debit transaction is one that leads to a payment to
foreigners.

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Balance of Payments: Illustration

Assume that transactions take place between USA. residents

and foreigners and that all payments are financed in dollars.
From the U.S. perspective, the following transactions are
credits (+), leading to the receipt of dollars from foreigners:
Merchandise exports
Transportation and travel receipts
Income received from investments abroad
Gifts received from foreign residents
Aid received from foreign governments
Investments in the United States by overseas residents

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Balance of Payments: Illustration

Conversely, the following transactions are debits (-) from the

U.S. view point because they involve payments to foreigners:
Merchandise imports
Transportation and travel expenditures
Income paid on investments of foreigners
Gifts to foreign residents
Aid given by the U.S. government
Overseas investment by U.S. residents

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Balance of Payments: Illustration

Although we speak in terms of credit transactions and debit

transactions, every international transaction involves an
exchange of assets and so has both a credit and a debit side.
Each credit entry is balanced by a debit entry, and vice versa,
so that the recording of any international transaction leads to
two offsetting entries.
In other words, the balance of-payments accounts utilize a
double-entry accounting system.

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Balance of Payment-Structure

The current account of the balance of payments refers to the

monetary value of international flows associated with
transactions in goods and services, investment income, and
unilateral transfers.
Merchandise trade includes all of the goods the country
exports or imports:
Agricultural products, machinery,autos, petroleum, electronics,
textiles, and the like.

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Balance of Payment-Structure

To get a broader understanding of the international

transactions of a country, we must add services to the
merchandise trade account.
This total gives the goods and services balance.
When this balance is positive, the result is a surplus on goods
and services transactions; a negative balance implies a deficit.
Just what does a surplus or deficit balance appearing on the
country goods and services account mean?
If the goods and services account shows a surplus, the country
has transferred more resources (goods and services) to
foreigners than it has received from them over the period of
one year.

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Balance of Payment-Structure

Besides measuring the value of the net transfer of resources,

the goods and services balance also furnishes information
about the status of a nation’s gross domestic product (GDP).
This is because the balance on the goods and services account
is defined essentially the same way as the net export of goods
and services, which is part of a nation’s GDP.
Recall from your macroeconomics course that GDP is equal to
the value of the goods and services produced in an economy
over a period of time.
In an economy with trade, GDP is equal to the sum of four
different types of spending in the economy: consumption,
gross investment, government spending, and net exports of
goods and services.
In effect, net exports represent the value of goods and services
that are produced domestically but not included in domestic
consumption.

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Balance of Payment-Structure

For a nation’s GDP, then, the balance on the goods and

services account can be interpreted as follows.
A positive balance on the account shows an excess of exports
over imports, and this difference must be added to the GDP.
When the account is in deficit,the excess of imports over
exports must be subtracted from the GDP.
If a nation’s exports of goods and services equal its imports,
the account will have a net imbalance of zero and will not
affect the status of the GDP.
Therefore, depending on the relative value of exports and
imports, the balance on the goods and services account
contributes to the level of a nation’s national product.

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Balance of Payment-Structure

Broadening our balance-of-payments summary further, we

must include income receipts and payments.
This item consists of the net earnings (dividends and interest)
on reporting country investments abroad-that is, earnings on
the reporting country investments abroad less payments on
foreign assets in the reporting country
It also includes compensation of employees.

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Balance of Payment-Structure

Our balance-of-payments summary is expanded to include

unilateral transfers.
These items include transfers of goods and services (gifts in
kind) or financial assets (money gifts) between the reporting
country and the rest of the world.
Private transfer payments refer to gifts made by individuals
and non-governmental institutions to foreigners.
These might include a remittance from an immigrant living in
the United States to relatives back home, a birthday present
sent to a friend overseas, or a contribution by a U.S. resident
to a relief fund for underdeveloped nations.

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Balance of Payment-Structure

Governmental transfers refer to gifts or grants made by one

government to foreign residents or foreign governments.
The U.S. government makes transfers in the form of money
and capital goods to underdeveloped nations, military aid to
foreign governments, and remittances such as retirement
pensions to foreign workers who have moved back home.
In some cases, U.S. governmental transfers represent payments
associated with foreign assistance programs that can be used
by foreign governments to finance trade with the United
States.
It should be noted that many U.S. transfer (foreign aid)
programs are tied to the purchase of US. exports (such as
military equipment or farm exports) and thus represent a
subsidy to U.S. exporters.

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Balance of Payment-Structure

When investment income and unilateral transfers are

combined with the balance on goods and services,
We arrive at the current account balance.
This is the broadest measure of a nation’s balance of
payments regularly quoted in the newspapers and in national
television and radio news reports.

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Balance of Payment-Structure

Capital and Financial Account

Capital and financial transactions in the balance of payments
include all international purchases or sales of assets.
The term assets is broadly defined to include items such as
titles to real estate, corporate stocks and bonds, government
securities, and ordinary commercial bank deposits.

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Balance of Payment-Structure

The capital and financial account’ includes both private sector

and official (central bank) transactions.
Capital transactions consist of capital transfers and the
acquisition and disposal of certain non-financial assets.
The major types of capital transfers are debt forgiveness and
migrants’ goods and financial assets accompanying them as
they leave or enter the country.
The acquisition and disposal of certain non-financial assets
include the sales and purchases of rights to natural resources,
patents, copyrights, trade marks, franchises, and leases.
Though conceptually important, capital transactions are
generally very small in U.S. accounts.
The vast majority of transactions appearing in the capital and
financial account come from financial transactions.

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Balance of Payment-Structure

The following are examples of private-sector financial

transactions:
Direct Investment : Direct investment occurs when residents of
one country acquire a controlling interest (stock ownership of
10 percent or more) in a business enterprise in another country.
Securities: Securities are private-sector purchases of short and
long-term debt securities, such as Treasury bills, Treasury
notes, Treasury bonds, and securities of private enterprises.

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Balance of Payment-Structure

’Since 1999, U.S. international transactions have been

classified into three groups-the current account, the capital
account, and the financial account.
The transactions were formerly classified into the current
account and capital account.
Bank Claims and Liabilities
Bank claims consist of loans, overseas deposits, acceptances,
foreign commercial paper, claims on affiliated banks abroad,
and foreign government obligations.
Bank liabilities include demand deposits and NOW (negotiable
order of withdrawal) accounts, passbook savings deposits,
certificates of deposit, and liabilitiesto affiliated banks abroad.
Capital and financial transactions are recorded in the
balance-of-payments statement by applying a plus sign (credit)
to capital and financial inflows and a minus sign (debit) to
capital and financial outflows.
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Balance of Payment-Structure

For the United States, a financial inflow might occur under

the following circumstances:
(1) U.S. liabilities to foreigners rise (for example, a French
resident purchases securities of IBM);
(2) U.S. claims on foreigners decrease (Citibank receives
repayment for a loan it made to a Mexican enterprise);
(3) foreign-held assets in the United States rise (Toyota builds
an auto-assembly plant in the United States);
(4) Ll.S. assets overseas decrease (Coca-Cola sells one of its
Japanese bottling plants to a Japanese buyer).
A financial outflow would imply the opposite.

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Balance of Payment-Structure

The following rule may be helpful in appreciating the

fundamental difference between credit and debit transactions
that make up the capital and financial account.
Any transaction that leads to the home country’s receiving
payments from foreigners can be regarded as a credit item.
A capital (financial) inflow can be likened to the export of
goods and services.
Conversely, any transaction that leads to foreigner’s receiving
payment from the home country is considered a debit item.
A capital (financial) outflow is similar in effect to the import
of goods and services.

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Balance of Payment-Structure

Besides including private-sector transactions, the capital and

financial account includes official settlements transactions of
the home country’s central bank.
Official settlements transactions refer to the movement of
financial assets among official holders (for example, the US.
Federal Reserve and the Bank of England).
These financial assets fall into two categories: official reserve
assets (U.S. government assets abroad) and liabilities to
foreign official agencies (foreign official assets in the United
States).

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Balance of Payment-Structure:Summary

The balance of payments is a summary statement in which, in

principle, all the transactions of the residents of a nation with
the residents of all other nations are recorded during a
particular period of time, usually a calendar year.
The main purpose of the balance of payments is to inform the
government of the international position of the nation and to
help it in its formulation of monetary, fiscal, and trade policies.

Governments also regularly consult the balance of payments of

important trade partners in making policy decisions.
The information contained in a nation’s balance of payments
is also indispensable to banks, firms, and individuals directly or
indirectly involved in international trade and finance.

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Balance of Payment-Double -Entry Bookkeeping

In recording a nation’s international transactions, the

accounting procedure known as double-entry bookkeeping is
used.
This means that each international transaction is recorded
twice, once as a credit and once as a debit of an equal
amount.
The reason for this is that in general every transaction has two
sides.
We sell something and we receive payment for it.
We buy something and we have to pay for it.

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Balance of payments accounting and accounts

An important point about a country’s balance-of-payments

statistics is that in an accounting sense they always balance.

This is because they are based upon the principle of double-entry

book-keeping.
Each transaction between a domestic and foreign resident has two
sides to it, a receipt and a payment, and both these sides are
recorded in the balance-of-payments statistics.
Each receipt of currency from residents of the rest of the world is
recorded as a credit item (a plus in the accounts) while each
payment to residents of the rest of the world is recorded as a debit
item (a minus in the accounts).

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Balance of payments accounting and accounts

Before considering some examples of how different types of

economic transactions between domestic and foreign residents get
recorded in the balance of payments, we need to consider the
various sub accounts that make up the balance of payments.
Traditionally, the statistics are divided into two main sections:
The current account (items in this part refer to income flows)
The capital account ( items in this part refer to records on changes
in assets and liabilities of the country)
Each part is further sub divided into sub-accounts.

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Balance of payments accounting and accounts

A) Current account
The current account can be divided into two sub accounts: visible
and invisible accounts.
The visible sub-account records the values of imported and exported
goods where as the invisible sub-account records values of imported
and exported services; interests, profits and dividends received;
interests, profits and dividends paid; unilateral receipts and
payments.
The balance on the visible accounts of the current account is termed
as the trade balance whereas the sum of the visible trade balance
and the invisible balance is termed as the current account balance
Trade Balance = Receipts for exported goods – Payments on
imported goods

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Balance of payments accounting and accounts

A) Current account

The trade balance is sometimes referred to as the visible balance

because it represents the difference between receipts for exports of
goods and expenditure on imports of goods which can be visibly
seen crossing frontiers.
The receipts for exports are recorded as a credit in the balance of
payments, while the payment for imports is recorded as a debit.
When the trade balance is in surplus this means that a country has
earned more from its exports of goods than it has paid for its
imports of goods.

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Balance of Payments:Balance of payments accounting and

accounts

Current Account Balance = Trade balance + Invisible Balance

The current account balance is the sum of visible trade balance and
the invisible balance.
The invisible balance shows the difference between revenue received
for exports of services and payments made for imports of services
such as shipping, tourism, insurance and banking.
In addition, receipts and payments of interest, dividends and profits
are recorded in the invisible balance because they represent the
rewards for investment in overseas companies, bonds and equity;
while payments reflect the rewards to foreign residents for their
investment in the domestic economy.
As such, they are receipts and payments for the services of capital
that earn and cost the country income just as do exports and
imports.
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Balance of Payments:Balance of payments accounting and

accounts

Note that there is an item referred to as unilateral transfer

included in the invisible balance;
These are payments or receipts for which there is no corresponding
quid pro quo (something given or received for something else).
Examples of such transactions are migrant workers’ remittances to
their families back home, the payment of pensions to foreign
residents, and foreign aid.
Such receipts and payments represent a redistribution of income
between domestic and foreign residents.
Unilateral payments can be viewed as a fall in domestic income due
to payments to foreigners and so are recorded as a debit; while
unilateral receipts can be viewed as an increase in income due to
receipts from foreigners and consequently are recorded as a credit.
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Balance of Payments:Balance of payments accounting and

accounts

B) Capital account

The capital account records transactions concerning the movement

of financial capital into and out of the country.
Capital comes into the country by borrowing, sales of overseas
assets, and investment in the country by foreigners.
These items are referred to as capital inflows and are recorded as
credit items in the balance of payments.
Capital inflows are, in effect, a decrease in the country’s holding of
foreign assets or increase in liabilities to foreigners.
The fact that capital inflows are recorded as credits in the balance
of payments often presents students with difficulty.

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Balance of Payments:Balance of payments accounting and

accounts

B) Capital account

Similarly investment by foreign residents is the export of equity or

bonds, while sales of overseas investments is an export of those
investments to foreigners.
Conversely, capital leaves the country due to lending, buying of
overseas assets, and purchases of domestic assets owned by foreign
residents.
These items represent capital outflows and are recorded as debits in
the capital account.

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Balance of Payments:Balance of payments accounting and

accounts

B) Capital account

Capital outflows are, in effect, an increase in the country’s holding

of foreign assets or decrease in liabilities to foreigners.
These items are recorded as debits as they represent the purchase,
the purchase of foreign bonds or equity, and the purchase of
investments in the foreign economy.
Items in the capital account are normally distinguished according to
whether they originate from the private or public sector, and
whether they are of a short-term or long-term nature.
The summation of the capital inflows and outflows as recorded in
the capital account gives the capital account balance.

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Balance of Payments:Balance of payments accounting and

accounts

C) Official settlements balance

Given the huge statistical problems involved in compiling the

balance-of payments statistics there will usually be a discrepancy
between the sum of all the items recorded in the current account,
capital account and the balance of official financing which in theory
should sum to zero.
To ensure that the credits and debits are equal it is necessary to
incorporate a statistical discrepancy for any difference between the
sum of credits and debits.

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Balance of Payments:Balance of payments accounting and

accounts

C) Official settlements balance

There are several possible sources of this error.
One of the most important is that it is an impossible task to keep
track of all the transactions between domestic and foreign residents;
many of the reported statistics are based on sampling estimates
derived from separate sources, so that some error is unavoidable.
Another problem is that the desire to avoid taxes means that some
of the transactions in the capital account are undereported.
Moreover some dishonest firms may deliberately under-invoice their
exports and over-invoice their imports to artificially deflate their
profits.

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Balance of Payments:Balance of payments accounting and

accounts

C) Official settlements balance

Another problem is that of ’leads and lags’.
The balance of payments records receipts and payments for a
transaction between domestic and foreign residents, but it can
happen that a good is imported but the payment delayed.
Since the import is recorded by the customs authorities and the
payment by the banks, the time discrepancy may mean that the two
sides of the transaction are not recorded in the same set of figures.

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Balance of Payments:Balance of payments accounting and

accounts

The summation of the current account balance, capital account

balance and the statistical discrepancy gives the official settlements
balance.

The balance on this account is important because it shows the

money available for adding to the country’s official reserves or
paying off the country’s official borrowing.
A central bank normally holds a stock of reserves made up of
foreign currency assets.
Such reserves are held primarily to enable the central bank to
purchase its currency should it wish to prevent it depreciating.

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Balance of Payments:Balance of payments accounting and

accounts

Any official settlements deficit has to be covered by the authorities

drawing on the reserves, or borrowing money from foreign central
banks or the IMF (recorded as a plus in the accounts).

If, on the other hand, there is an official settlements surplus then

this can be reflected by the government increasing official reserves
or repaying debts to the IMF or other sources overseas (a minus
since money leaves the country).

The fact that reserve increases are recorded as a minus, while

reserve falls are recorded as a plus in the balance-of-payments
statistics is usually a source of confusion.

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Balance of Payments:Balance of payments accounting and

accounts

It is most easily rationalized by thinking that reserves increase

when the authorities have been purchasing foreign currency
because the domestic currency is strong.

This implies that the other items in the balance of payments are in
surplus, so reserve increases have to be recorded as a debit to
ensure overall balance.

Conversely, reserves fall when the authorities have been supporting

a currency that is weak; that is, all other items sum to a deficit so
reserve falls must be recorded as a plus to ensure overall balance.

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Balance of Payments Disequilibria

Balance of Payments Disequilibria

3.5.1. Balance of Payments Surpluses and Deficits

3.5.2. Financing Balance of Payments Deficit
3.5.3. Exchange Rates and the Balance of Payments

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Balance of Payments Surpluses and Deficits

It follows that an excess quantity supplied of the domestic currency

is equivalent to a current account deficit.

Likewise, an excess quantity demanded of the domestic currency is

equivalent to a current account surplus.

The current account is in balance when the quantity of the

domestic currency supplied and the quantity demanded are equal.

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Balance of Payments Surpluses and Deficits

Balance of Payments Disequilibria

A disequilibrium in the balance of payment means its condition of
Surplus Or deficit
A Surplus in the BOP occurs when Total Receipts exceeds Total
Payments. Thus, BOP= CREDIT>DEBIT
A Deficit in the BOP occurs when Total Payments exceeds Total
Receipts. Thus, BOP= CREDIT<DEBIT

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Balance of Payments Surpluses and Deficits

Causes of Disequilibrium In The Bop

Cyclical fluctuations
Short fall in the exports
Economic Development
Rapid increase in population
Structural Changes
Natural Calamites
International Capital Movements

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Balance of Payments Surpluses and Deficits: Measures To Correct Disequilibrium

in the BOP

Measures To Correct Disequilibrium in the BOP:Monetary

measures :-
a) Monetary Policy

The monetary policy is concerned with money supply and credit in

the economy.
The Central Bank may expand or contract the money supply in the
economy through appropriate measures which will affect the prices.

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Balance of Payments Surpluses and Deficits: Measures To Correct Disequilibrium

in the BOP

Measures To Correct Disequilibrium in the BOP:Monetary

measures :-
b) Fiscal Policy : Tax or Expendurre

Fiscal policy is government’s policy on income and expenditure.

Government incurs development and non - development
expenditure,.
It gets income through taxation and non - tax sources.
Depending upon the situation governments expenditure may be
increased or decreased.

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Balance of Payments Surpluses and Deficits: Measures To Correct Disequilibrium

in the BOP

Measures To Correct Disequilibrium in the BOP:Monetary

measures :-
C) Exchange Rate- Depreciation

By reducing the value of the domestic currency, government can

correct the disequilibrium in the BoP in the economy.
Exchange rate depreciation reduces the value of home currency in
relation to foreign currency.
As a result, import becomes costlier and export become cheaper.
It also leads to inflationary trends in the country

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 Balance of Payment

Balance of Payments Surpluses and Deficits: Measures To Correct Disequilibrium

in the BOP

Measures To Correct Disequilibrium in the BOP:Monetary

measures :-
C) Exchange Rate -Devaluation
Devaluation is lowering the exchange value of the official currency.
When a country devalues its currency, exports becomes cheaper and
imports become expensive which causes a reduction in the BOP
deficit.

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 Balance of Payment

Balance of Payments Surpluses and Deficits: Measures To Correct Disequilibrium

in the BOP

Measures To Correct Disequilibrium in the BOP:Monetary

measures :-
D). Deflation

Deflation is the reduction in the quantity of money to reduce prices

and incomes.
In the domestic market, when the currency is deflated, there is a
decrease in the income of the people.
This puts curb on consumption and government can increase
exports and earn more foreign exchange.

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 Balance of Payment

Balance of Payments Surpluses and Deficits: Measures To Correct Disequilibrium

in the BOP

Measures To Correct Disequilibrium in the BOP:Monetary

measures :-
E). Exchange Control
All exporters are directed by the monetary authority to surrender
their foreign exchange earnings, and the total available foreign
exchange is rationed among the licensed importers.
The license-holder can import any good but amount if fixed by
monetary authority.

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Balance of Payments Surpluses and Deficits: Measures To Correct Disequilibrium

in the BOP

Measures To Correct Disequilibrium in the BOP:Non- Monetary

measures :-
a) Export Promotion
To control export promotions, the country may adopt measures to
stimulate exports like:
Export duties may be reduced to boost exports cash assistance,
Subsidies can be given to exporters to increase exports goods meant
for exports can be exempted from all types of taxes.

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 Balance of Payment

Balance of Payments Surpluses and Deficits: Measures To Correct Disequilibrium

in the BOP

Measures To Correct Disequilibrium in the BOP:Non- Monetary

measures :-
b) Import Substitutes Steps may be taken to encourage the
production of import substitutes.

This will save foreign exchange in the short run by replacing the use
of imports by these import substitutes
Import Control Import may be kept in check through the adoption
of a wide variety of measures like quotas and tariffs.

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 Balance of Payment

Balance of Payments Surpluses and Deficits: Measures To Correct Disequilibrium

in the BOP

Measures To Correct Disequilibrium in the BOP:Non- Monetary

measures :-
Under the quota system, the government fixes the maximum quantity of
goods and services that can be imported during a particular time period.

1. Quotas – Under the quota system, the government may fix and
permit the maximum quantity or value of a commodity to be
imported during a given period.
By restricting imports through the quota system, the deficit is
reduced and the balance of payments position is improved.
2. Tariffs – Tariffs are duties (taxes) imposed on imports. When
tariffs are imposed, the prices of imports would increase to the
extent of tariff.
The increased prices will reduced the demand for imported
goods and at the same time International
induce domestic producers
Economics to
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produce more of import substitutes
 Balance of Payment

Exchange Rates and the Balance of Payments

How Real Exchange Rate Changes Affect the Current Account

The current account measures the value of exports relative to the

value of imports:CA ≈ EX –IM.
When the real exchange rate E = P ∗ /P rises, the prices of foreign
products rise relative to the prices of domestic products.
The volume of exports that are bought by foreigners rises.
The volume of imports that are bought by domestic residents falls.
The value of imports in terms of domestic products rises:
The value/price of imports rises, since foreign products are more
valuable/expensive

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 Balance of Payment

Exchange Rates and the Balance of Payments

How Real Exchange Rate Changes Affect the Current Account

If the volumes of imports and exports do not change much, the value
effect may dominate the volume effect when the real exchange rate
changes.
For example, contract obligations to buy fixed amounts of products may
cause the volume effect to be small. However, evidence indicates that for
most countries the volume effect dominates the value effect in 1 year or
less.

Therefore, we assume that a real depreciation leads to an increase in the

current account:
The volume effect dominates the value effect

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Exchange Rates and the Balance of Payments

Determinants of the current account include:

Real exchange rate:Real exchange rate: prices of foreign products relative

to the prices of domestic products, both measured in domestic currency:
E = P ∗ /P
As the prices of foreign products rise relative to those of domestic
products, expenditure on domestic products rises and expenditure on
foreign products falls.
An increase in the real exchange rate increases the current account.

Disposable income:
More disposable income means more expenditure on foreign products
(imports)
An increase in the disposable income decreases the current account

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 Balance of Payment

Exchange Rates and the Balance of Payments-Aggregate

Demand

Determinants of aggregate demand include:

Real exchange rate:

An increase in the real exchange rate increases the current account, and
therefore increases aggregate demand for domestic products==>import
to be reduced .

Disposable income: an increase in the disposable income increases

consumption, but decreases the current account==> import to be
increased
Since total consumption expenditure is usually greater than expenditure
on foreign products, the first effect dominates the second effect.
As income increases for a given level of taxes, aggregate consumption and
aggregate demand increases by less than income.
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Exchange Rates and the Balance of Payments-Aggregate

Demand

Aggregate Demand Model Construction:

For simplicity, we assume that exogenous political factors determine

government purchases G and the level of taxes T.

For simplicity, we currently assume that investment expenditure I is

determined exogenously.

A more complicated model shows that investment depends on the cost of

borrowing for investment, the interest rate

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 Balance of Payment

Exchange Rates and the Balance of Payments-Aggregate

Demand

Aggregate Demand Model Construction:

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 Balance of Payment

Exchange Rates and the Balance of Payments: The

Demand for and Supply of Foreign Exchange

The demand for a nation’s currency is dependent upon foreign

residents’ demand for its exports==>

It depends on foreign residents’ desire to obtain the domestic currency to

facilitate their purchases of the domestic country’s exports.

The supply of a nation’s currency is dependent upon (among other

things) domestic residents’ demand for imports==>

When a nation’s residents import, they supply the domestic currency as

payment.

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Exchange Rates and the Balance of Payments: The

Demand for and Supply of Foreign Exchange

Price Elasticity of Demand is a measure of the responsiveness of

quantity demanded to a change in price.

If quantity demanded is highly responsive to a change in price, then

demand is said to be relatively elastic.

If quantity demanded is not very responsive to a change in price, then

demand is said to be relatively inelastic.

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 Balance of Payment

Exchange Rates and the Balance of Payments: The

Demand for and Supply of Foreign Exchange

The Effect of Exchange Rate Changes

The exchange rate is an important price to an economy.

When a nation’s currency depreciates, domestic goods become relatively
cheaper and foreign goods relatively more expensive in the global market.

Hence, we would expect the nation’s exports to rise and imports to decline.

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 Balance of Payment

Exchange Rates and the Balance of Payments:

Pass-through effect

Pass-through effects are also important to understanding the

response of the current account to changes in the exchange rate.

A pass-through effect is when the domestic price of an imported good

rises following the depreciation of the domestic currency.

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 Balance of Payment

Approaches to Balance of Payments

Approaches to Balance of Payments

3.6.1. Elasticity Approach to Balance of Payments

3.6.2. Absorption Approach to Balance of Payments

3.6.3. Monetary Approach to Balance of Payments

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Approch to Balance of Payments

What is Balance of Payments

The balance of payments is an economic indicator used to determine the
economic and political stability of a country.
The BOP gauges the goods and services, trade balance and financial
imports and exports between one country and the rest of the world over a
specified period of time.
The BOP compares all imports and exports, including financial
transactions, and compares the monetary difference between the
transactions.
If a country has a positive BOP, it means the country has more money
coming from international trade than going out.
On the other hand, a negative BOP indicates a country has more money
flowing out through international trade then coming in.
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 Balance of Payment

Elasticity Approach to Balance of Payments

The Elasticity Approach to Balance of Payments

The value of a country’s currency depends on the overall economy of the

country.

This includes manufacturing, foreign investments, employment, trade balance

and many other economic indicators.

All of the transactions that the country conducts with other countries
represent part of the balance of payment.

Economists use different tools to analyze and come up with methods for
increasing, decreasing and balancing trade between countries.

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Elasticity Approach to Balance of Payments

What is Elasticity?
Elasticity represents responsiveness.

In economics, elasticity determines how demand changes when you change

something about a product or service.

In most cases, the concept of elasticity demonstrates how demand of a product

or service will change as a result of a price increase or decrease.

The elasticity approach to the balance of payments demonstrates how

the change in the value of the currency affects a country’s balance of
payments.

The elasticity approach tries to predict the outcome policy changes will have on
the balance of payments.

This approach illustrates how exchange rates will affect the balance of payment.
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 Balance of Payment

Elasticity Approach to Balance of Payments

The Elasticity Approach

The elasticity approach assumes that if the BOP is in equilibrium,

devaluation can improve the balance of payments.

However, for devaluation to function successfully, the total of the price

elasticity of domestic and foreign demand for imports has to increase.

When a country devalues a currency, it improves the balance of payments

under ideal conditions.

This ideal condition is known as the Marshall-Lerner condition.

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Elasticity Approach to Balance of Payments

The Responsiveness of Imports and Exports

The elasticities approach, therefore, considers the responsiveness of the

quantity of imports and the quantity of exports to a change in the value
of a nation’s currency.

For example, if import demand is highly elastic, a depreciation of the domestic

currency will cause a relatively larger decline in the nation’s imports.

The Role of Elasticity

The amount of depreciation required to eliminate this deficit depends on

elasticity.

When demand and supply are relatively more elastic, a smaller deprecation is
required to eliminate the current account deficit.

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Elasticity Approach to Balance of Payments

The Marshall-Lerner Condition

Named after English economist Alfred Marshall and Romanian economist

Abba Lerner,
The Marshall-Lerner Condition states that a currency devaluation will
eventually improve the balance of payments.

In order to accomplish this increase in the BOP, however, the sum of demand
elasticity for imports and spply elatisticity of exports has to increase.

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 Balance of Payment

Elasticity Approach to Balance of Payments

The Marshall-Lerner Condition

When a country devalues its currency, the price of exports will decrease.

This, in theory, will increase the demand for these exports.

However, for increased demand to occur, the exported products have to be

elastic products.

Will a depreciation always improve the current account balance?

The Marshall-Lerner condition specifies the necessary conditions for the current
account to improve.

According to this condition, the current account balance will improve if the
sum of the elasticity of import demand and the elasticity of export supply
exceed unity.
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 Balance of Payment

Elasticity Approach to Balance of Payments :The J-Curve

Effect

The J-Curve Effect

The current account balance may respond differently to a currency
change in the short run relative to the long run.
The J-Curve effect refers to a phenomenon in which a depreciation of the
domestic currency causes a nation’s balance of payment to worsen before
it improves.
Initially, there is a current account deficit of $40 million. At time t, the
dollar depreciates (Refer figure in the next slide)
In the short run, import demand and export supply may be inelastic and the
current account widens to $48 million.

Eventually, as businesses and households have time to adjust their planned

expenditures on imports and exports, the deficit improves.
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 Balance of Payment

Elasticity Approach to Balance of Payments :The J-Curve

Effect

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 Balance of Payment

Elasticity Approach to Balance of Payments :The J-Curve

Effect

The elasticities approach emphasizes price changes as a

determinant of a nation’s balance of payments and exchange rate.

The elasticities approach is helpful in understanding the different

outcomes that might arise from the short to long run.

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 Balance of Payment

Absorption Approach to Balance of Payments

The absorption approach to the balance of payments states that a

country’s balance of trade will only improve if the country’s output
of goods and services increases by more than its absorption,

Where the term ’absorption’ means expenditure by domestic residents on

goods and services

The absorption approach emphasizes changes in real domestic

income as a determinant of a nation’s balance of payments and
exchange rate.

Because it treats prices as constant, all variables are real measures.

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 Balance of Payment

Absorption Approach to Balance of Payments

Expenditure

A nation’s expenditures fall into four categories, consumption (c),

investment (i), government (g), and imports (m).

The total of these four categories is referred to as domestic absorption (a)

a =c +i +g +m

Real Income

A nation’s real income (y ) is equivalent to total expenditures on its

output
y = c + i + g + x , where x denotes exports.

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 Balance of Payment

Absorption Approach to Balance of Payments

The Absorption Approach emphasizes real income in

balance-of-payments and exchange-rate determination.

The approach hypothesizes that relative changes in real income or output

and absorption determine a nation’s balance-of-payments and
exchange-rate performance.

It is not clear that expenditure switching and absorption instruments are

effective.

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 Balance of Payment

Absorption Approach to Balance of Payments: Current

Account

During the time (early Bretton Woods era) that the absorption
model was developed, capital flows were not very important.

Trade flows, therefore, determined the current account balance.

Hence, the current account (ca) is equivalent to

ca = x − m.

Then, for example, if exports exceed imports, x > m, and the

nation is running a current account surplus.

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 Balance of Payment

Absorption Approach to Balance of Payments: Current

Account Determination

The absorption approach hypothesizes that a nation’s current

account balance is determined by the difference between real
income and absorption, which can be written as:

y − a = (c + i + g + x ) − (c + i + g + m) = x − m, or y − a = ca.

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 Balance of Payment

Absorption Approach to Balance of Payments:

Contradiction and Expanision

Though a simple theory, the absorption approach is helpful in

understanding a nation’s external performance during contractions
and expansions.

For example, when a nation experiences an economic contraction,

Does its current account necessarily improve and does its currency definitely
appreciate?

Does the opposite necessarily hold during an economic expansion?

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 Balance of Payment

Absorption Approach to Balance of Payments: Economic

Expanision

Consider the case of an economic expansion.

Real income rises, there by increasing real expenditures or absorption.

Whether the current account balance improves or worsens depends on

the relative changes in these two variables.

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 Balance of Payment

Absorption Approach to Balance of Payments: Current

account Adjustment

If real income rises faster than absorption, then the current

account improves

y > a → ca > 0.

If real income rises slower than absorption, then the current

account worsens

y < a → ca < 0.

Similar conclusions can be reached for a nation experiencing an

economic contraction.

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 Balance of Payment

Absorption Approach to Balance of Payments: Exchange

Rate Determination

The absorption approach can also be used to examine how changes

in income affect the value of a nation’s currency.
Recall that y − a = x − m.

For example, if real income is rising faster than absorption, then exports
must be increasing relative to imports.

Hence, the nation’s currency will appreciate.

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 Balance of Payment

Absorption Approach to Balance of Payments: Policy

Implication

A nation may resort to absorption instruments or expenditure

switching instruments to correct an external imbalance.

The effectiveness of these instruments, however, is uncertain, as can be

seen in the model.

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 Balance of Payment

Absorption Approach to Balance of Payments: Policy

Instrument

Absorption Instrument:

Influences absorption by altering expenditures.

Suppose the government reduces its expenditures (g).

Absorption will decline as g declines. However, since expenditures decline, so

does output.

The absorption instrument is effective only if absorption declines faster than

output.

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 Balance of Payment

Absorption Approach to Balance of Payments: Policy

Instrument

Expenditure Switching Instrument:

Alters expenditures among imports and exports by changing relative

prices.

Suppose the government devalues the domestic currency.

Imports are relatively more expensive, and exports are relatively cheaper.

If households and businesses switch directly between imports and domestic

output without changing overall absorption or income, there is no impact on
the current account balance.

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 Balance of Payment

Monetary Approach to Balance of Payments

A Simple Monetary Model

There are three key assumptions that underlie the monetary model.
These are:

A stable money demand function,

A vertical aggregate supply curve, and

Purchasing power parity (PPP).

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Monetary Approach to Balance of Payments

A) Stable money demand function

The most basic postulate of the monetary approach to the balance of

payments is that there is a stable demand for money function that is
made up of only a few variables.

The monetarists use the quantity theory of money as the basis of the
money demand function, which is written as:

Md = kPy .............................(1)

Where Md is the demand for nominal money balances,P is the

domestic price level, y is real domestic income, and k is a
parameter that measures the sensitivity of money demand to
changes in nominal income.
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Monetary Approach to Balance of Payments

A) Stable money demand function

The demand for money is a positive function of the domestic price level
because it is a demand for real money balances.

A rise in the domestic price level will reduce real money balances (M/P)
and accordingly lead to an equiproportionate increase in the demand for
money.

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Monetary Approach to Balance of Payments

A) Stable money demand function

The money demand function forms the basis of the aggregate demand
curve.
From equation 1

If we hold the money supply (money demand) fixed and assume that k is a
fixed parameter, this means that an increase in Y requires an equiproporrionate
fall in the price level.

A fall in the price level given a fixed money supply will create excess real money
balances(M/P) and this leads to increased aggregate demand.

An increase in the money supply has the effect of shifting the aggregate
demand curve to the right.

This is because at any given price level there is a rise in real money balances
which leads to increased aggregate demand.
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Monetary Approach to Balance of Payments

B) Vertical aggregate supply curve

The simple monetary model assumes that the labor market is sufficiently
flexible that the economy is continuously at the full employment level of
output.

In other words, wages are sufficiently flexible that they are constantly at
the level that equates the supply and demand for labor.
A rise in the domestic price level does not lead to an increase in domestic
output because wages adjust immediately to the higher price level so that
there is no advantage for domestic producers to take on more labor.

This means that the aggregate supply curve is vertical at the full employment
level of output.

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Monetary Approach to Balance of Payments

B) Vertical aggregate supply curve

Although the aggregate supply curve is vertical at the full employment

level of output, this does not mean that output is always constrained to
be fixed ;

The aggregate supply curve may shift to the right if there is an

improvement in productivity due to technological progress, which means
that full employment is associated with a higher level of real output.

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Monetary Approach to Balance of Payments

C) Purchasing power parity

The final assumption that underpins the monetary model is that of
purchasing power parity (PPP).
In its simplified version, the theory says that the exchange rate adjusts so
as to keep the following equation in equilibrium:

P
S= ==> P = SP ∗.....................................................................(2)
P∗
Where S is the exchange rate defined as domestic currency per unit of
foreign currency, so that a rise is depreciation and a fall is an appreciation
of the domestic currency,
P is the domestic price level in the domestic currency, and
P ∗ is the foreign price in the foreign currency.
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Monetary Approach to Balance of Payments

C) Purchasing power parity

In figure 7.3, we depict the PPP relationship between the domestic price
and the exchange rate.

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Monetary Approach to Balance of Payments

C) Purchasing power parity

The PPP curve shows combinations of the domestic price level and
exchange rate which are compatible with PPP given the foreign price
level P ∗ .

Points to the left of the PPP curve depict an overvaluation of the

domestic currency in relation to PPP, whereas points to the right depict
undervaluation in relation to PPP.

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Monetary Approach to Balance of Payments

The simple monetary model invokes the three assumptions set out
above and then proceeds with the use of some accounting
identities and behavioral assumptions to develop a theory of the
balance of payments.

The domestic monetary supply in the economy is made up of two

components:

Ms = D + R − − − − − − − − − − − (3)

Where: Ms is the domestic money base, D the domestic bond

holdings of the monetary authorities, and R the reserves of foreign
currencies valued in the domestic currency.

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Monetary Approach to Balance of Payments

Equation 3 says that the domestic money base is made up of two

components. This monetary base can come into circulation in one
of two ways:
1. The authorities may conduct an open market operation (OMO) which
is a purchase of treasury bonds (held by private agents) by the central
bank.

This increases the central bank’s monetary liabilities but increases its assets of
domestic bond holdings which is the domestic component of the monetary base
as represented by D.

2. The authorities may conduct a foreign exchange operation (FXO)

which is a purchase of foreign currency assets (money or foreign treasury
bonds) held by private agents by the central bank.

This again increases the central bank’s monetary liabilities but increases its
assets of foreign currency and foreign bonds which are represented by R.
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Monetary Approach to Balance of Payments

We can now rewrite equation 3 in its derivative form as:

dMs = dD + dR − − − − − − − − − − − − − −(4)

Equation 4 states that any increase (decrease) in the domestic

money supply can come about through either an OMO as
represented by dD, or a FXO as represented by dR.

The relationship between the money supply and reserves is depicted in

Figure 7.4.

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Monetary Approach to Balance of Payments

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Monetary Approach to Balance of Payments

Figure 7.4 show that

At point D1, all the domestic money supply is made up entirely of the
domestic component since reserves are zero.
For convenience, we set the exchange rate of domestic to foreign
currency equal to unity;

This being the case an increase of 1 unit of foreign currency leads to an

increase in the domestic money supply of 1 unit, so that when reserves are R1
the money s

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Monetary Approach to Balance of Payments

Figure 7.4 show that

An OMO will have the effect of shifting the MS curve by the amount of
the increase in the central bank’s domestic bond holdings.
An OMO which increases the domestic component of the monetary base
from D1 to D2 shifts the money supply curve from MS1 to MS2, and
the total money supply rises from M1 to M2.

Money Supply is M1 , where M1 = D1 + R1.

By contrast, an expansion of the money supply due to a purchase of

foreign currencies, that is an FXO, increases the country’s foreign
exchange reserves from R1to R2.

This too has the effect of raising the money stock from M1 to M2 and is
represented by a movement along the money supply curve MS1 from point A
to point B.
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Monetary Approach to Balance of Payments

The Monetarist Concept of Balance of Payments Disequilibrium

The monetarists view balance of payments surpluses and deficits as

monetary flows due to stock disequilibrium in the money market.

A deficit in the balance of payments is due to an excess of the stock of money

in relation to money demand, while a surplus is a monetary flow resulting from
an excess demand for money in relation to the stock of money supply.

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Monetary Approach to Balance of Payments

The Monetarist Concept of Balance of Payments Disequilibrium

Thus balance of payments disequilibrium is merely a reflection of

disequilibrium in the money market.

In this sense, the monetary flows are the ’autonomous’ items in the balance of
payments, while the purchases and sales of goods/services and investments
(long, medium and short-term) are viewed as the ’accommodating’ items.

This is completely the reverse of the Keynesian approach which views the
current account items as the autonomous items and capital account and
reserve changes as the accommodating items.

This different way of looking at the balance-of-payments statistics is sometimes

contrasted by saying that Keynesians look at the statistics from the ’top down’
(that is, the current account), while the monetarists look from the ’bottom up’
(the change in reserves).

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 Balance of Payment

Monetary Approach to Balance of Payments

The Monetarist Concept of Balance of Payments Disequilibrium

Monetarists observe that the overall balance of payments can be thought

of as consisting of the current account balance, the capital account
balance, and change in the authorities’ reserves. That is:

BP = CA + K + dR = 0 − − − − − − − − − − − − − (5)

CA + K = −dR − − − − − − − − − − − − − − − − − (6)

Where CA is the current account balance, K is the capital account

balance, and dR is the change in the authorities’ reserves, BP is
the monetarist balance of payment.

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 Balance of Payment

Monetary Approach to Balance of Payments

The Monetarist Concept of Balance of Payments Disequilibrium

If the recorded dR in the balance-of-payments accounts is positive, this

means that the combined current account and capital accounts are in
deficit.

This implies that reserves have fallen as the authorities have purchased the
home currency with foreign currency reserves.

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Mengesha.Y(Ph.D.)
 Balance of Payment

Monetary Approach to Balance of Payments

The Monetarist Concept of Balance of Payments Disequilibrium

Equation 6 is a distinct way of viewing the balance of payments;

Increases in reserves due to purchases of foreign currencies constitute a surplus

in the balance-of-payments, while falls in reserves resulting from purchases of
the domestic currency represent a deficit in the balance of payments.

If the authorities do not intervene in the foreign exchange market, that is

the currency is left to float, then reserves do not change and as far as the
monetary view is concerned the balance of payments is in equilibrium.

Under a floating exchange-rate regime, a current account deficit must be

financed by an equivalent capital inflow so the balance of payments is in
equilibrium.

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 Balance of Payment

Monetary Approach to Balance of Payments: The Effects

of a Devaluation

The monetary approach argues that devaluation can only have an

affect on the balance of payments by influencing the demand for
money in relation to the supply of money.

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Mengesha.Y(Ph.D.)
 Balance of Payment

Monetary Approach to Balance of Payments: The Effects

of a Devaluation

The immediate effect of a devaluation of the exchange rate from

S1 to S2 is to make domestic goods competitive in relation to
PPP at point A.

As domestic goods become more competitive compared to foreign goods,

there is an increase in the demand for the domestic currency as
represented by a shift of the money demand curve from Md1 to Md2.

This means that money demand M2 exceeds the money supply Ml.

International Economics II (Econ 634) (U

Mengesha.Y(Ph.D.)
 Balance of Payment

Monetary Approach to Balance of Payments: The Effects

of a Devaluation

The competitive advantage of the devaluation means that the

balance of payments moves into surplus as domestic residents
demand less foreign goods/services, while foreigners demand more
domestic goods.

To prevent the domestic currency appreciating, the authorities have to

purchase the foreign currency with new domestic money base.

This increases the reserves and leads to an expansion of the domestic money
supply which in turn raises aggregate demand for domestically-produced goods.

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 Balance of Payment

Monetary Approach to Balance of Payments

The aggregate demand curve shifts to the right from AD1 to AD2
and starts pushing up domestic prices until PPP is restored at price
P2.
Once the domestic price level is at P2 and the money supply has
increased to M2, real money balances will be at their equilibrium level
(M1/P1 = M2/P2) and the competitive advantage of the devaluation
has been offset.
The balance of payments will be back in equilibrium as the money supply
is once again equal to money demand.
In the long run, the effect of X per cent devaluation is to lead to
an X per cent rise in the domestic price level, and X per cent
increase in the domestic money stock.
In other words, the surplus resulting from devaluation is merely a
transitory phenomenon.
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 Balance of Payment

Traditional Approach

Traditional approaches to balance-of-payments and exchange-rate

determination assume that capital flows occur only to finance
real-sector transactions.

The quantity of foreign exchange demanded and the quantity of foreign

exchange supplied depend only on international transactions of goods
and services.

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Mengesha.Y(Ph.D.)
 Balance of Payment

Balance of Payments

GNP = Expenditure on a Country’s Goods and Services

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 Balance of Payment

Balance of Payments:Expenditure and Production in Open

Economy

CA = EX –IM = Y –(C + I + G)
When production > domestic expenditure, exports > imports:
current account > 0, trade balance > 0

When a country exports more than it imports,

It earns more income from exports than it spends on imports

Net foreign wealth is increasing

International Economics II (Econ 634) (U

Mengesha.Y(Ph.D.)
 Balance of Payment

Balance of Payments:Expenditure and Production in Open

Economy

When production < domestic expenditure, exports < imports:

current account < 0, trade balance < 0

When a country exports less than it imports,

It earns less income from exports than it spends on imports

Net foreign wealth is decreasing

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 Balance of Payment

Balance of Payments: Saving and Current Accout

National saving (S) = national income(Y ) that is not spent on

consumption (C ) or government purchases (G).
Y –C –G(Y –C –T ) + (T –G)Sp + Sg = S
How is the Current Account Related to National Saving?

CA = Y –(C + I + G) implies CA = (Y –C –G)–I = S–I

Current account = national saving – investment

Current account = net foreign investment

International Economics II (Econ 634) (U

Mengesha.Y(Ph.D.)
 Balance of Payment

Balance of Payments: Saving and Current Accout

How is the Current Account Related to National Saving?

A country that imports more than it exports has low national saving
relative to investment.
CA = S–IorI = S–CA
Countries can finance investment either by saving or by acquiring foreign
funds equal to the current account deficit.
A current account deficit implies a financial capital inflow or negative net
foreign investment.
When S > I, then CA > 0 and net foreign investment and financial capital
outflows for the domestic economy are positive.

CA = Sp + Sg–I = Sp– government deficit – I

Government deficit is negative government saving equal to G–TA ==>high
government deficit causes a negative current account balance, all other things
equal. International Economics II (Econ 634) (U
Mengesha.Y(Ph.D.)
 Appendix

References

Appleyard, Dennis R. and Field, Alfred J. (1998), International Economics, Irwin

McGraw - Hill, Boston, U.S.A.

Krugman, Paul and Maurice Obstfeld (1997), International Economics: Theory

and Policy, Addison – Wesley Longman, Inc. California, U. S. A.

Salvatore, Dominic (1995), International Economics, Prentice hall International,

Inc.

Sodersten, B. and G. Reed (1994), International Economics, New York: St.

Martin’s Press, U.S.A.

Alemayehu G. (2012), Fundamental of International Economics for Developing

Countries: A Focus on Africa: Volume I, Trade Theory, Policy and Practice
(Nairobi: AERC and Moran Publishers).

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