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BBA 4 Semester
Macroeconomics
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4 Unit Notes
What Is the Balance of Payments (BOP)?

The balance of payments (BOP), also known as the balance of international

payments, is a statement of all transactions made between entities in one country
and the rest of the world over a defined period, such as a quarter or a year. It
summarizes all transactions that a country's individuals, companies, and
government bodies complete with individuals, companies, and government
bodies outside the country.

The balance of payments includes both the current account and capital account.
The current account includes a nation's net trade in goods and services, its net
earnings on cross-border investments, and its net transfer payments.
The capital account consists of a nation's transactions in financial instruments
and central bank reserves.
The sum of all transactions recorded in the balance of payments should be zero;
however, exchange rate fluctuations and differences in accounting practices may
hinder this in practice.

Understanding the Balance of Payments (BOP)

The balance of payments (BOP) transactions consist of imports and exports of

goods, services, and capital, as well as transfer payments, such as foreign aid and
remittances. A country's balance of payments and its net international investment
position together constitute its international accounts.

The balance of payments divides transactions into two accounts: the current
account and the capital account. Sometimes the capital account is called the
financial account, with a separate, usually very small, capital account listed
separately. The current account includes transactions in goods, services,
investment income, and current transfers.

Components of BoP

Now let’s understand the different components of the BoP. The BoP consists of
three main components—current account, capital account, and financial account.
As mentioned earlier, the BoP should be zero. The current account must balance
with the combined capital and financial accounts.
Current Account

The current account monitors the flow of funds from goods and services trade
(import and export) between countries. Now this includes money received or spent
on manufactured goods and raw materials. It also includes revenue from tourism,
transportation receipts, revenue from specialized services (medicine, law,
engineering), and royalties from patents and copyrights. In addition, the current
account includes revenue from stocks.

Capital Account

The capital account monitors the flow of international capital transactions. These
transactions include the purchase or disposal of non-financial assets (for example,
land) and non-produced assets. The capital account also includes money received
from debt-forgiveness and gift taxes. In addition, the capital account records the
flow of the financial assets by migrants leaving or entering a country and the
transfer, sale, or purchase of fixed assets.

Financial Account

The financial account monitors the flow of funds pertaining to investments in

businesses, real estate, and stocks. It also includes government-owned assets such
as gold and Special Drawing Rights (SDRs) held with the International Monetary
Fund (IMF). In addition, it includes foreign investments and assets held abroad by
nationals. Similarly, the financial account includes a record of the assets owned by
foreign nationals.

Why is BoP important?

The BoP statement provides a clear picture of the economic relations between
different countries. It is an integral aspect of international financial
management. Now that you have understood BoP and its components, let’s look at
why it is important.

To begin with, the BoP statement provides information pertaining to the demand
and supply of the country’s currency. The trade data shows a clear picture of
whether the country’s currency is appreciating or depreciating in comparison with
other countries. Next, the country’s BoP determines its potential as a constructive
economic partner. In addition, a country’s BoP indicates its position in
international economic growth.
By studying its BoP statement and its components closely, a country would be able
to identify trends that may be beneficial or harmful to the economy and take
appropriate measures.

Balance Of Payment (BOP) is a statement that records all the monetary

transactions made between residents of a country and the rest of the world during
any given period. This statement includes all the transactions made by/to
individuals, corporates and the government and helps in monitoring the flow of
funds to develop the economy.

When all the elements are correctly included in the BOP, it should be zero in a
perfect scenario. This means the inflows and outflows of funds should balance out.
However, this does not ideally happen in most cases.

A BOP statement of a country indicates whether the country has a surplus or a

deficit of funds, i.e. when a country’s export is more than its import, its BOP is
said to be in surplus. On the other hand, the BOP deficit indicates that its imports
are more than its exports.

Tracking the transactions under BOP is similar to the double-entry accounting

system. All transactions will have a debit entry and a corresponding credit entry.

For example:
Funds entering a country from a foreign source are booked as credit and recorded
in the BOP. Outflows from a country are recorded as debits in the BOP. Let’s say
Japan exports 100 cars to the U.S. Japan books the export of the 100 cars as a debit
in the BOP, while the U.S. books the imports as a credit in the BOP.

What is the Formula for Balance of Payments?

The formula for calculating the balance of payments is current account + capital
account + financial account + balancing item = 0.

Why is the Balance of Payment (BOP) vital for a country?

A country’s BOP is vital for the following reasons:

 The BOP of a country reveals its financial and economic status.

 A BOP statement can be used to determine whether the country’s currency
value is appreciating or depreciating.
  The BOP statement helps the government to decide on fiscal and trade
policies.
 It provides important information to analyse and understand the economic
dealings with other countries.

By studying its BOP statement and its components closely, one would be able to
identify trends that may be beneficial or harmful to the county’s economy and,
thus, then take appropriate measures.

Elements of a Balance of Payment

There are three components of the balance of payment viz current account, capital
account, and financial account. The total of the current account must balance with
the total of capital and financial accounts in ideal situations.

Current Account

The current account monitors the inflow and outflow of goods and services
between countries. This account covers all the receipts and payments made with
respect to raw materials and manufactured goods.

It also includes receipts from engineering, tourism, transportation, business

services, stocks, and royalties from patents and copyrights. When all the goods and
services are combined, they make up a country’s Balance Of Trade (BOT).

There are various categories of trade and transfers which happen across countries.
It could be visible or invisible trading, unilateral transfers or other
payments/receipts. Trading in goods between countries is referred to as visible
items, and import/export of services (banking, information technology etc.) are
referred to as invisible items.

Unilateral transfers refer to money sent as gifts or donations to residents of foreign

countries. This can also be personal transfers like – money sent by relatives to
their family located in another country.

Capital Account
All capital transactions between the countries are monitored through the capital
account. Capital transactions include purchasing and selling assets (non-financial)
like land and properties.

The capital account also includes the flow of taxes, purchase and sale of fixed
assets etc., by migrants moving out/into a different country. The deficit or surplus
in the current account is managed through the finance from the capital account and
vice versa. There are three major elements of a capital account:

 Loans and borrowings – It includes all types of loans from the private and
public sectors located in foreign countries.
 Investments – These are funds invested in corporate stocks by non-
residents.
 Foreign exchange reserves – Foreign exchange reserves held by the
country’s central bank to monitor and control the exchange rate do impact
the capital account.

Financial Account

The flow of funds from and to foreign countries through various investments in
real estate, business ventures, foreign direct investments etc., is monitored through
the financial account. This account measures the changes in the foreign ownership
of domestic assets and domestic ownership of foreign assets. Analysing these
changes can be understood if the country is selling or acquiring more assets (like
gold, stocks, equity, etc.).

Illustration

If, for the year 2018, the value of exported goods from India is Rs. 80 lakh and the
value of imported items to India is 100 lakh, then India has a trade deficit of Rs. 20
lakh for the year 2018. The BOP statement acts as an economic indicator to
identify the trade deficit or surplus situation. Analysing and understanding the
BOP of a country goes beyond just deducting the outflows of funds from inflows.
As mentioned above, there are various components of BOP and fluctuations in
these accounts, which provide a clear indication of which economic sector needs to
be developed.

Frequently Asked Questions

What is the importance of the Balance of Payments in India?

The importance of the balance of payment in India can be determined from the
following points:

 It monitors the transaction of all the imports and exports of services and
goods for a given period.
 It helps the government analyse a particular industry’s export growth
potential and formulate policies to sustain it.
 It gives the government a comprehensive perspective on a different range of
import and export tariffs. The government then increases and decreases the
tax to discourage imports and encourage export, individually, and self-
sufficiency.

What is the difference between the balance of trade and payments?

Balance of trade is the difference between exports and imports of goods. Only the
visible items are considered in the balance of trade. The exchange of services
between countries is not considered.

The current account of the balance of payment comprises exports and imports of
goods, services and unilateral transfers like remittances, gifts, donations, etc. The
net value of all these constitutes the balance of the current account. Thus, the
balance of trade is a part of the current account of the balance of payments.

What are the sources of supply of foreign exchange?

The sources of supply of foreign exchange are:

 Purchase of goods and services by foreigners

 Foreign Direct Investment (FDI) into our country
 Inflow by the NRIs settled in foreign countries
 Speculative purchase of home currency by foreigners

What is the meaning of a deficit in the balance of payments?

When autonomous foreign exchange payments exceed autonomous foreign

exchange receipts, the balance of payments deficit is the difference. Autonomous
transactions in foreign exchanges are those transactions that are independent of the
state’s balance of payments and are undertaken for an individual’s own sake.
What are official reserve transactions and their importance in the balance of
payments?

Official reserve transactions mean running down the country’s foreign exchange
reserves in case of a deficit in the balance of payments by selling foreign currency
in the foreign exchange market. In surplus, the country can buy foreign exchange
and increase its official reserves.

A country is said to be having its balance of payment in equilibrium when the sum
of its current account and non-reserve capital account equals zero, which means the
current account deficit is financed entirely by international borrowings without any
movement in the country’s official reserves.

Components of balance of payment

The balance of payments includes three essential components that measure income,
trade, ownership of assets and transactions of a country. The current account,
financial account and capital account are the three primary elements that
economists look at to evaluate a nation's financial and economic standing within
international markets:

Current account

The current account tracks a nation's balance of trade along with the effects direct
payments and net income have on its economic standing. When a country's citizens
make purchases, these funds are what provide the country with the savings and
income it needs to fund its purchases, business activities and its spending on
infrastructure. When a nation's consumer spending is enough to cover these
activities, the current account stays in balance.

However, when a nation's current account is in deficit, it means its citizens spend
more on imported goods than they keep in savings. A current account deficit can
result in a nation borrowing money from another to fund its deficit. Over time,
economic growth can slow if the deficit country is unable to get out of debt.

Financial account

A country's financial account reflects the changes in its ownership of any foreign
assets, along with foreign ownership over its own assets. The financial account is
in balance when a country's ownership over foreign assets equals the ownership
that other nations have over its domestic assets. If a country's foreign ownership
increases faster than its domestic ownership, a deficit can develop. If a deficit
arises in the financial account of a nation's balance of payments, it means the
nation sells more assets than it gains.

Capital account

The capital account is usually the smallest component of the balance of payment,
and it tracks all the financial processes that do not affect a country's production,
income or savings. This means that if a nation initiates a transaction like a transfer
of copyrights or trademarks or cross-border payments on insurance premiums, it
records this occurrence in the capital account. Since many of the economic and
financial activities nations take part in typically have direct impacts on income,
savings and production, transactions within the capital account can be rare.

Related: What Is Asset Management?

Importance of the balance of payments

The balance of payments and the components of balance of payment are crucial for
understanding a nation's financial and economic standing. This metric also shows
whether the value of a country's currency is appreciating or depreciating.
Additionally, many financial professionals in roles like investment management,
government policy-making and federal banking use a nation's balance of payments
to direct the research, analysis and development of policies and strategies that
support the nation's growth. Consider several more important uses of the balance of
payments and its components:

Decision-making

The balance of payments is an extremely important metric for decision-making at

the national level. Professionals like economists, federal accountants, policymakers
and others use the data from a nation's balance of payments to make decisions
about how to adapt production and exportation to increasing or decreasing price
levels, interest rates, inflation rates and employment rates.

Developing trade policies

Governments refer to the balance of payments to develop trade policies since the
data the balance of payments provides gives insight into the economic transactions
between one country and other nations. The insight economists can gain from
analyzing the balance of payments helps them identify beneficial and harmful
trends, which can allow them to create trade policies that help nations reach
important objectives and support economic growth.

Establishing fiscal objectives

Governments also rely on data from the balance of payments to set important
objectives that lead their nations toward positive economic development. For
instance, if a country is in a deficit, it relies on its balance of payments to strategize
approaches for getting out of its deficit. These fiscal objectives can include things
like increasing production on a GDP in high demand, borrowing from another
nation or even making trade agreements with other nations. With fiscal objectives
in place, a country can better understand its economic and financial growth.

Related: The Difference Between Objectives and Goals

Implementing growth strategies

The balance of payments helps governments understand where to place focus to

achieve fiscal objectives and consistent economic growth. The data that
governments analyze from the balance of payments can help them create strategies
that support their nations' growth and status within international markets.
Additionally, understanding whether a nation is in deficit or surplus is highly
important for developing the most effective and beneficial strategies for growth.

Analyzing deficits

The balance of payments essentially highlights whether a country is in deficit or

surplus. The data economists analyze in the balance of payments can help them
better understand the reasons behind a nation's deficit so they can develop ways to
solve it. Additionally, analyzing deficits using the information from the balance of
payments allows economists to better allocate domestic funds to get out of its
deficit and achieve growth.

Investing with surplus

Just as the balance of payments helps economists analyze deficits, it also helps
economists determine how to invest surpluses. When a nation has surpluses in
gross domestic products and other assets, it can reinvest these funds into its
economy. This can lead to more availability in jobs, resources, domestic goods and
services and other domestic assets. Countries with surpluses in the balance of
payments may also decide to assist nations in deficit.

Balance of Payments

The BoP or balance of payments records the undertakings or transactions of

commodities, assets, and services between the citizens of a nation with the rest of
the world for a stated time frame frequently every year. There are two main
accounts in the BoP.

 Current account
 Capital account

Meaning

 The balance of payment is a systematic record of all the economic/monetary

transactions between the residents (all the units) of a country and the rest of
the world in an accounting year.
 It is prepared on the principles of the double-entry system.

Current Account Definition

The current account is a record of businesses in commodities, transfer payments,

and services. Trade-in commodities comprise the exports and imports of
commodities. Trade-in services comprise factor income and non-factor income
transactions or undertakings.

Transfer payments are the receipts that the citizens of a nation get for free’, without
having to provide any commodities or services in return. They consist of
remittances, grants, and gifts. They could be provided by the government or by
private residents living abroad.

Capital Account Definition

The capital account records all the international undertakings of assets. An asset is
any one of the types in which wealth can be held. For instance, stocks, bonds,
government debt, money, etc. The purchase of assets is a debit on the capital
account. If an Indian purchases a UK car company, it enters the capital account
undertakings as a debit (as foreign exchange is going out of India).
On the other hand, the sale of assets, like the sale of the share of an Indian
company to a Japanese customer, is a credit on the capital account. These items are
foreign direct investments (FDIs), foreign institutional investments (FIIs),
assistance, and external borrowings.
What is the Balance of Payments?

The Balance of Payments is a statement that contains the transactions made by

residents of a particular country with the rest of the world over a specific time
period. It is also known as the balance of international payments and is often
abbreviated as BOP. It summarizes all payments and receipts by firms, individuals,
and the government. The transactions can be both factor payments and transfer
payments.

There are two accounts in the BOP statement: the Current Account and Capital
Account. The Current account records all transactions involving goods, services,
investment income, and current transfer payments. The Capital account shows the
net change in ownership of foreign assets and transactions in financial instruments.

The balance of payments account follows a double-entry system. All receipts are
entered on the credit side, whereas all payments are entered on the debit side.
Theoretically, a balance of payments accounts is always zero, with the total on the
debit side equaling the total on the credit side. Practically, however, there might be
an error of some degree due to the different sources of data and fluctuation of
currency exchange rates.
Components of BOP

The BOP comprises two accounts: Current and Capital.

Current Account

The four major components of the Current account are as follows:

1. Visible trade – This is the net of export and imports of goods (visible
items). The balance of this visible trade is known as the trade balance. There
is a trade deficit when imports are higher than exports and a trade surplus
when exports are higher than imports.
2. Invisible trade – This is the net of exports and imports of services (invisible
items). Transactions mainly consist of shipping, IT, banking, and insurance
services.
3. Unilateral transfers to and from abroad – These refer to payments that
are not factor payments – for example, gifts or donations sent to the resident
of a country by a non-resident relative.
4. Income receipts and payments – These include factor payments and
receipts. These are generally rent on property, interest on capital, and profits
on investments.

Capital Account

The capital account is used to finance the deficit in the current account or absorb
the surplus in the current account. The three major components of the capital
account:

1. Loans to and borrowings from abroad – These consist of all loans and
borrowings given to or received from abroad. It includes both private sector
loans, as well as public sector loans.
2. Investments to/from abroad – These are investments made by nonresidents
in shares in the home country or investment in real estate in any other
country.
3. Changes in foreign exchange reserves – Foreign exchange reserves are
maintained by the central bank to control the exchange rate and ultimately
balance the BOP.
A Current account deficit is financed by a surplus in the Capital account and vice
versa. This can be done by borrowing more money from abroad or lending more
money to non-residents.

Significance of BOP

The balance of payments data is important to a lot of users. Investment managers,

government policymakers, the central bank, businessmen, etc., all use the BOP
data to make important decisions. The BOP data is affected by vital
macroeconomic variables such as exchange rate, price levels, interest rates,
employment, and GDP.

Monetary and fiscal policies are formed in a way to achieve very specific
objectives, which generally exert a significant impact on the balance of payments.
Policies can be formed with the objectives to induce or curb foreign inflows or
outflows.

Businesses use BOP to analyze the market potential of a country, especially in the
short term. A country with a large trade deficit is not as likely to import as much as
a country with a trade surplus. If there is a large trade deficit, the government may
adopt a policy of trade restrictions, such as quotas or tariffs.

Foreign Exchange

he Foreign Exchange Market is a market where buyers and sellers trade foreign
currencies. Simply stated, a foreign exchange market is a market where various
countries' currencies are bought and sold.

The FOREX market trading is a financial network that allows for global
exchanges. The key functions of the foreign exchange market, which are the
product of its operation, are as follows:

 Function of Transfer

The movement of funds (foreign currency) from one country to another for
payment settlement is the most essential and noticeable feature of the foreign
exchange market. It essentially involves the exchange of one currency for
another, with FOREX's function being to shift purchasing power from one country
to another.
For example, if an Indian exporter imports goods from the United States and the
payment is to be made in dollars, FOREX trading online would facilitate the
conversion of the rupee to the dollar. Credit instruments such as bank drafts,
foreign exchange bills, and telephone transfers are used to carry out the transfer
purpose.

 Function of Credit

FOREX offers importers a short-term loan to help with the seamless transfer of
products and services from one country to the next. An importer can fund foreign
purchases with credit. If an Indian company wants to buy machinery in the United
States, it can pay for it by issuing a bill of exchange in the foreign exchange market
with a three-month maturity.

 Function of Hedging

A foreign exchange market's third role is to hedge foreign exchange risks. Foreign
exchange participants are also concerned about variations in exchange rates, or the
price of one currency in terms of another. The party affected by the change in the
exchange rate could benefit or lose money.

As a result of this, FOREX trading online offers services for hedging expected or
current claims/liabilities in return for forward contracts. A forward contract is a 12-
week deal to purchase or sell foreign exchange for another currency at a price
decided upon today at a future date. As a consequence, no money is exchanged
during the contracting process.

A foreign exchange market is where one currency is traded for another. There is a
demand for each currency and a supply of each currency. In these markets, one
currency is bought using another. The price of one currency in terms of another
(for example, how many dollars it costs to buy one Mexican peso) is called the
exchange rate.

Foreign currencies are demanded by domestic households, firms, and governments

who wish to purchase goods, services, or financial assets that are denominated in
the currency of another economy. For example, if a US auto importer wants to buy
a German car, it must buy euros. The law of demand holds: as the price of a
foreign currency increases, the quantity of that currency demanded will decrease.

Foreign currencies are supplied by foreign households, firms, and governments

that wish to purchase goods, services, or financial assets denominated in the
domestic currency. For example, if a Canadian bank wants to buy a US
government bond, it must sell Canadian dollars. As the price of a foreign currency
increases, the quantity supplied of that currency increases.

Exchange rates are determined just like other prices: by the interaction of supply
and demand. At the equilibrium exchange rate, the supply and demand for a
currency are equal. Shifts in the supply or demand for a currency lead to changes
in the exchange rate. Because one currency is exchanged for another in a foreign
exchange market, the demand for one currency entails the supply of another. Thus
the dollar market for euros (where the price is dollars per euro and the quantity is
euros) is the mirror image of the euro market for dollars (where the price is euros
per dollar and the quantity is dollars).

To be concrete, consider the demand for and supply of euros. The supply of euros
comes from the following:

 European households and firms that wish to buy goods and services from
non-euro countries
 European investors who wish to buy assets (government debt, stocks, bonds,
etc.) that are denominated in currencies other than the euro

The demand for euros comes from the following:

 Households and firms in non-euro countries that wish to buy goods and
services from Europe
 Investors in non-euro countries that wish to buy assets (government debt,
stocks, bonds, etc.) that are denominated in euros

Figure 17.17 "The Foreign Exchange Market" shows the dollar market for euros.
On the horizontal axis is the quantity of euros traded. On the vertical axis is the
price in terms of dollars. The intersection of the supply and demand curves
determines the equilibrium exchange rate.

Mundell-Fleming Model:

Meaning of the Mundell-Fleming Model:

The basic Mundell-Fleming model — like the IS-LM model — is based on the
assumption of fixed price level and shows the interaction between the goods
market and the money market.
The model explains the causes of short-run fluctuations in aggregate income (or,
what comes to the same thing, shifts in the ad curve) in an open economy.

The Mundell-Fleming model is based on a very restrictive assumption. It considers

a small open economy with perfect capital mobility.

This means that the economy can borrow or lend freely from the international
capital markets at the prevailing rate of interest since its domestic rate of interest is
determined by the world rate of interest. So, the rate of interest is not a policy
variable in the small economy being studied.

This means that macroeconomic adjustment occurs only through exchange rate
changes. In other words, the brunt of adjustment is borne by exchange rate
movements in foreign exchange markets to maintain the officially determined
exchange rate. The central bank permits the exchange rate to move up or down in
response to changing economic conditions.

The basic assumption of this model is that the domestic rate of interest (r) is equal
to the world rate of interest (r*) in a small open economy with perfect capital
mobility. No doubt any change within the domestic economy may alter the
domestic rate of interest, but the rate of interest cannot stay out of line with the
world rate of interest for long.

The difference between the two, if any, is removed quickly through inflows and
outflows of financial capital.

It may be recalled that “smallness” of a country has no relation to its size. A small
country is one which cannot alter the world rate of interest through its own
borrowing and lending activities. In contrast, a large economy is one which has
market (bargaining) power so that it can exert influence over the world rate of
interest.

For such a country, either international capital mobility is far from perfect, or the
country is so large that it can exert influence on world capital markets.

The main prediction from the Mundell-Fleming model is that the behaviour of an
economy depends crucially on the exchange rate system it adopts, i.e., whether it
operates a floating exchange rate system or a fixed exchange rate system. We start
with adjustment under a floating exchange rate system, in which case there is no
central bank intervention in the foreign exchange market.
In such a situation, if the domestic interest rate goes above the world rate,
foreigners will start lending to the home country. This capital inflow will create
excess supply of funds and the domestic rate of interest r again will fall to r*.

The converse is also true. If, for some reason, the domestic rate of interest (r) falls
below r*, there will be capital outflow from the home country and the resulting
shortage of funds will push up r to the level of r*. Thus, in a world of perfect
capital mobility, r will quickly get adjusted to r*.

The Open Economy IS Curve:

In the Mundell-Fleming model, the market for goods and services is expressed
by the following equation:

Y = C(Y – T) + I(r*) + G + NX(e) … (1)

where all the terms have their usual meanings. Here investment depends on the
world rate of interest r* since r = r* and NX depends on the exchange rate e which
is the price of a foreign currency in terms of domestic currency.

In the Mundell-Fleming model, it is assumed that the price levels at home and
abroad remain fixed. So, there is no difference between real exchange rate and
nominal exchange rate. We now illustrate the equation of the goods market
equilibrium in Fig. 12.1.