ADDIS ABABA UNIVERSITY COLLEGE

OF BUSSINES AND ECONOMICS

DEPARTMENT OF ECONOMICS
Course Title: Research Methods and Applied Econometrics (Econ 654)

Proposal title: The Impact of Political Instability on Balance of

Payments in sub-Saharan Africa

Prepared by Zelalem Hailu

ID: GSE/1100/10

Submitted: Atnafu G/meskel (Ph.D.)

February 2021
Addis Ababa, Ethiopia

Table of Contents
Abstract....................................................................................................................................................l
CHAPTER ONE......................................................................................................................................1
INTRODUCTION...................................................................................................................................1
1.1. Background..................................................................................................................................1
1.2. Statement of the problem.............................................................................................................3
1.3. Research questions.......................................................................................................................5
1.4. Research hypothesis.....................................................................................................................5
1.5. Research objective............................................................................................................................5
1.5.1. General Objectives.........................................................................................................................5
1.5.2. Specific Objectives........................................................................................................................6
1.6. Research Methodology.....................................................................................................................6
1.6.1. Data source....................................................................................................................................6
1.6.2. Tentative Econometric model........................................................................................................6
1.6.3. Method of Data Analysis...............................................................................................................7
1.7. Scope and limitation of the study......................................................................................................9
1.7.1. Scope of the study..........................................................................................................................9
1.7.2. Limitations of the Study................................................................................................................9
1.8. Significance of the study..................................................................................................................9
1.9. Organization of the study................................................................................................................10
CHAPTER TWO...................................................................................................................................11
LITERATURE REVIEW......................................................................................................................11
2.1. Theoretical literature.......................................................................................................................11
2.1.1. Political instability.......................................................................................................................11
2.1.2. Balance of payments....................................................................................................................12
2.1.2.1. Absorption Approach................................................................................................................14
2.1.2.2. Elasticity approach....................................................................................................................15
2.1.2.3. The Monetary Approach...........................................................................................................17
2.2. Empirical literature.........................................................................................................................18
2.3. Evaluation of the Literature............................................................................................................20
2.4. Approach of the study and Conceptual framework.........................................................................21
References.............................................................................................................................................22
Abstract
Political instability may happen in a different country in different forms but Africa is one of the
victims of this undesirable situation for many decades. An unstable political environment
opposes production and trades for the country; hence trade of a country affected the current
account balance will be affected this brings the balance of payment to be a deficit. This study
will show how the effect of unstable political environments affects the components of the
balance of payments in one way or another way in sub-Saharan African countries.

Keyword: balance of payments, political instability, and current account balance

 CHAPTER ONE

INTRODUCTION

1.1. Background
Political instability is a major problem for most countries in the world; nevertheless, sub-Saharan
African countries are on the front line. According to (Bello-Schünemann and Moyer, 2018) for
the past two-decade Sub-Saharan Africa has made substantial peace and security but people are
dying in war and other forms of political violence have increased, and the region’s future will
still be turbulent. Political instability holds back economic growth and development; this has
been shown in sub-Saharan African countries(Mbaku, 2016).

Political instability brings many undesirable effects in socio-economics sectors. This paper tries
to show the effect of political instability on the country's balance of payments. We look at data
across selected sub -Saharan African countries in different regions to study the relationship
between political instability and balance of payments and to determine any outcome of political
instability on the balance of payments.

The Balance of Payments records all transactions that cross a country’s borders. There are
various ways that these transactions can be categorized and organized. Most Balances of
payment presentations give us two large categories: the current account and the capital account.
This study mainly focused on how political instability affects the current account balances of the
balance of payments. According to (Camdessus, 1993) the Current account balance is subdivided
into three broad categories: trade balance (which is subdivided into goods and services), income,
and current transfers (unilateral transfer).

Trade balances record the value of exports and imports of both goods and services. Examples of
goods are final consumer goods, raw materials, and intermediate capital goods while services
include transportation, construction services, communication services banking, insurance,
tourism, travel services, financial services, computer and information services, royalties and
license fees, personal, cultural and recreational services, government services and expenses on
education.
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Income balances are comprised of items such as compensation of employees, interest, rent,
profits, dividends, and royalties received from foreign countries and paid out to foreign
countries. Items that makeup transfers account balances are gifts, grants and reparation receipts,
and payments to foreign countries. Transfers can be government transfers or private transfers.
Government transfers are normally given either for economic, political, or humanitarian reasons
on the other hand; private transfers are remitted or received from foreign countries on a person –
to- personal basis.

(Fieleke, 1996)stated as the unilateral transfer may, of course, be made or received by the private
or the public sector. Among those between private parties, the major categories include transfers
by migrants of their possessions from their former to their new residences, remittances by
migrant workers from their new residences to relatives or others in the countries the migrants
have departed, and gifts, contributions, and pension payments between individuals and private
organizations residing in different countries. Among the transfers in which official organizations
participate, either with each other or with private parties, the major categories include financial
grants or grants of material or technical assistance, cancellation of debt, and payment of
pensions, taxes, and fees.

The balance of the Payments account has to balance out overall; there may be imbalances in the
components (either in the capital account or in the current account) that lead to surpluses or
deficits. When there is a deficit in the current account there must be a surplus in the capital
account to balance it out and vice versa. A balance of payments deficit is when the payments
made by a country are greater than the payments received by the country. The opposite of a
deficit is a surplus, where the payments received exceed the payments made by the country.

A current account deficit is sustainable when its underlying drivers support a smooth correction
in the future. It is unsustainable when symptomatic of macroeconomic imbalances that would
eventually trigger disruptive adjustments. Although a current account deficit in itself is neither
good nor bad, it is likely to be unsustainable and leads to harmful consequences when it is
persistently large, fuels consumption rather than investment occurs alongside excessive domestic

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credit growth, follows an overvalued exchange rate, or accompanies unrestrained fiscal deficits
(Devadas and Loayza, 2018).
Even though a current account deficit is often paralleled by deteriorating net foreign assets, it
may not be as informative about immediate-term financial vulnerabilities as the size, maturity,
and currency composition of gross financial stocks. Moreover, the most balance of payments
problems arises in connection with a deficit in the current account, mainly because imports
exceed exports over a long period. A current account deficit is caused by many factors, from the
know factors political instability is the principal factor for current account deterioration.

According to Godfrey M. Kariuki (2009). The current account, being one of the indicators used
to determine the future behavior of an economy forms part of the everyday decision process of
policymakers because of its closeness to many variables of the economy and other
macroeconomic variables. Due to the importance of the current account balance in any economy,
it is prudent to know the factors or the variables that affect and understand the changes in the
current account balance to make informed economic decisions. To sum up, this study will show
how the current account balance is affected by political instability.

1.2. Statement of the problem

(Mustafa, Nawaz, and Rubab, 2017) explained the impact of a stable and unstable political
system in a contrasting way. Political stability plays a prime role in keeping the nation unite and
maintaining rule of law in the country. Political stability is an imperative need for the economic
growth, social cohesion, and supremacy of the law. The development and success of a nation and
state without a secure, solid, and orderly political system is not possible and the government
becomes a tug of war amongst numerous vested interests. In case of instability, the condition is
inverse people feel dissatisfied and helpless, lose their confidence in the state and promote their
interest, and eventually, society is divided into warring groups fighting with one another to
secure their interest(Capabilities and Campaign, 2016).

Political instability decreases the benefits of the deals with domestic partners because all political
connections with unstable governments have a shorter expected time horizon. Political instability
also changes the magnitudes of other effects in the model. It decreases the importance of
property rights protection, intensifies the effect of wealth bias in a system, and magnifies the

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effect of pre-tax returns on investment for the relative value of foreign portfolio investment
(FPI).

(ALWIN, Mohammad; OQAILY, 2017) explained the performance of the balance of payments
with all of its components dominates the movement of macroeconomic variables. Changes and
imbalances that occur in the items of the balance of payment influence the internal balance of the
economy. For example, the trade balance is one of the most important sections of the current
account, which in turn represents an important part of the balance of payment. International trade
plays an important role in most international economies through import and export activities.
These activities, in turn, affect the commodity, labor, monetary and financial markets.

The increase in the deficit of trade balance caused by rising imports can lead to higher domestic
inflation levels due to the impact of imported inflation on domestic price levels. The effect of the
current account is not limited to the trade balance. The other components of the current account
affect the local economy, such as current transfers and the balance of services. Current transfers,
represented mainly in foreign aid and workers' remittances, help to provide the necessary
liquidity to support the economic development plans and production projects, as well as to
satisfy consumers’ needs, which in turn positively affect economic growth.

Despite the relatively extensive theoretical and empirical literature, there is no consensus on the
determinants of the balance of payments, especially in an unstable political environment of
countries. It means that the nature, performance, and determinants of the balance of payments
remain an empirical problem in different countries. When the prediction of a balance of
payments is not reliable it becomes very hard for a country to attract foreign investors, an
economy cannot be able to manage external shocks especially on exports or imports, and the
application of appropriate economic policy becomes hard.

A point to note is that when a country doesn’t manage its current account/trade balance and
capital account it is subjected to political control/influence by foreign governments and
international bodies like International Monetary Fund, United Nations, and World Bank. But
when a country’s trades were in balance, its internal demand for goods and services would be

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met by internal producers, but this may not be happening in many sub-Saharan African countries
because of the unstable political system.

Domestic producers can’t produce sufficient product for domestic consumption the political
system affects their production capacity, so the country will import more rather than exporting
this will lead the country to current account balance deterioration. In general, this paper tries to
show how political instability affects the balance of payment through the current account
balance.

1.3. Research questions

The research questions will be:

(i) What are the main determinants of the current account balance in the sub-Saharan
African countries?
(ii) How political instability affects the balance of payments?
(iii) What was the magnitude of the effect of political instability on the current account
balance?
(iv) What were the policy options for a favorable current account balance in sub-Saharan
African countries?

1.4. Research hypothesis

Problem Statement: What is the causal relationship between political instability and the balance
of payments?
Null Hypothesis (H0):
Political instability is not hurting the balance of payment
Alternative Hypothesis (H1):
Political instability hurts the balance of payments

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1.5. Research objective

1.5.1. General Objectives

The main objective of this study is to examine the empirical and theoretical relationship between
the balance of payments and political instability for selected sub-Saharan African countries'
economy employing annual data from 2000 to 2020.

1.5.2. Specific Objectives

The specific objectives are,

i. To gain a better understanding of the main determinants of the current account balance
in sub-Saharan African countries.
ii. To examine the effect of political instability on the balance of payment in sub-Saharan
African countries.
iii. To identify the magnitude and effect of political instability on the current account
balance in sub-Saharan African countries.
iv. To draw appropriate fiscal and monetary policy conclusions to correct the current
account balance difficulties in the future.

1.6. Research Methodology

1.6.1. Data source

The data set used in this paper is panel data based on selected sub-Saharan African countries.
The study used secondary data sources. Research data for this study focus on political instability
and balance of payments and other economic variables that have been known as determinants of
the current account balance. Annual data on economic and political variables, from 2000 to 2020
were gathered from selected sub-Saharan African countries. The data were acquired by using the
most reliable resources such as the International Monetary Fund (IMF), World Bank (WB),
global economic monitor (GEM), and central banks of countries in the research.

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1.6.2. Tentative Econometric model
To investigate the relationships between the current accounts balance and other main
macroeconomic variables and political instability in sub-Saharan African countries, the basic
model to be estimated is as follows:

𝑪𝑨𝑩𝒊,𝒕=𝜶𝟎+𝜶𝟏𝑩𝑻𝑩𝒊,𝒕 +𝜶2𝑮𝑭𝑪𝑭𝒊,𝒕+𝜶3INF𝒊,𝒕+𝜶4OE𝒊,𝒕+𝜶5𝑮𝑫𝑺𝒊,𝒕+𝜶6𝑪𝑻𝑻𝒊,𝒕+𝜶7𝑪𝑷𝑰𝒊,𝒕+
𝜶8REX𝒊,𝒕 +𝜶9PI𝒊,𝒕+𝜺𝒊,𝒕 ……………………………………………..(1.1)
Definitions of variable
𝑪𝑨𝑩- current account balance
𝑩𝑻𝑩- the balance of trade balance
𝑮𝑭𝑪𝑭- gross fixed capital formation
INF- Inflation rate
OE - Openness of the economy
𝑮𝑫𝑺- grosses domestic saving
𝑪𝑻𝑻- changes in terms of trade
𝑪𝑷𝑰- consumer price index
REX- real exchange rate
PI- political instability

Table 1.1: Postulated Signs of the Coefficients of Explanatory Variables.

Dependent variable Explanatory Variables Expected Sign

balance of trade balance - or +

gross fixed capital formation +

Inflation rate -
The openness of the economy - or +
grosses domestic saving +
changes in terms of trade - or +
Current Account Balance
consumer price index +

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 real exchange rate +
political instability -

1.6.3. Method of Data Analysis

The Vector autoregression (VAR) method was used since there is an insufficient theory that
connects these variables and cannot adopt any other theory. The choice of the VAR is since all
the variables are treated symmetrically in a structural sense with each variable having an
equation explaining its evolution based on its lags and the lags of the other variables in the model
and no prior knowledge about the variables is required. VAR’s modeling is also advocated for
because is it a theory-free technique. The VAR involved the estimation of nine regression
equations in which the current value of each variable was expressed as a function of lagged
values of itself and the other variables.
The following sequential procedure will be adopted:
Step I: Unit root test and order of integration
We conducted a stationarity test to establish the presence of a unit root using Augmented
Dickey-Fuller (ADF) tests. The test was done to help avoid the problem of spurious and
inconsistent regression results.

Step II: A cointegration analysis

The second step is to identify whether all the variables that are included in the system are
cointegrated, Cointegration before the VAR analysis was conducted to determine whether the
variables exhibited long-run or short-run relationship. We used the Johansen test to detect the
presence of cointegration. Accordingly, variables if found to be cointegrated, implies that there
exists a linear, stable, and long-run relationship among variables, such that the disequilibrium
errors would tend to fluctuate around zero mean. This means that variables tend to move together
to their steady-state path in the long run.

Step III: Vector Error-Correction Modeling (VECM)

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The purpose of the VECM is to focus on the short-run dynamics while making them consistent
with the long-run solution. If several variables are found to be cointegrated with at least one
cointegrating vector, then there always exists a corresponding error-correction representation
which implies that changes in the dependent variable can be formulated as a function of the level
disequilibrium in the cointegration relationship and fluctuation in other explanatory variables. In
other words, the error-correction term in the VECM provides an additional channel for the
detection of Granger causality. The Granger causality can be detected through the statistical
significance of the t-test for the lagged error correction term and of the F-test applied to the joint
significance of the sum of lags of each explanatory variable. The non-significance of both the t-
and F-test in the system indicates the econometric homogeneity of the dependent variable. In
addition to indicating the direction of causality amongst variables, the VECM also allows us to
discriminate the short-run and long-run Granger causality. The F-test of the explanatory
variables (in their first differences) indicates the “Short-run” causal effects, whereas the “long-
run” causal relationship is implied through the significance of the t-test of the error correction
term since it contains long-run cointegration information between the variables because it is
derived from the long-term cointegration relationship(s).

1.7. Scope and limitation of the study

1.7.1. Scope of the study

This study focuses on how political instability and balance of payments are connected. Now a
day globally the business and the economic environment are mostly affected by internal and
external shocks. One of the shocks that affect the business and the economic environment is an
unstable political system and always current account is the primary victim of this situation. Due
to this reason, we need to examine the country-specific macro-economic variables like the
current account. By carrying out a deeper study of the current account, it will provide an
opportunity for a deeper understanding of determinants that affect the current account balances
of a country.

1.7.2. Limitations of the Study

There are certain limitations of the current study which we have identified as follows:
 Data availability concerning variables of political instability: dependence on secondary
sources. Primary data is very expensive to get.

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  The total number of political instability variables used in the current study consists of one
variable. The current research has a “built-in” assumption that these indicators of
instability are appropriate in the context of sub-Saharan African countries.
 Limitation of a specific topic related to this study

1.8. Significance of the study

Political instability is a very scary and severe problem in the modern world; it affects both
developing countries as well as developed countries. Because of political instability, the political
environment of the country becomes uncertain and this will reduce the level of investment,
increase the rate of public debt, and slows down the speed of the development process and
economic growth of the country. Balance of payment worsening is one of the main causes of
political instability.
This study will be beneficial to the government of sub-Saharan African countries since it will
inform how political instability affects the current account and capital account of the balance of
payments when preparing the national policies. The study will contribute more knowledge about
the current account issues and will assist the private sector on the importance of trade, diaspora
remittances on the current account of the country. Finally, the study will give a way for future
studies in this area.

1.9. Organization of the study

This paper consists of two chapters and an overview of the content of each chapter presented as
follows:

 Chapter One: this chapter is the introduction part and mainly contains the background of
the study and statement of the problem, which gives an overview about the study of how
political instability and balance of payments are interconnected. This chapter also
discusses the scope of the study, the significance of the study, objectives of the study, and
methodology.
 Chapter Two: This chapter covers the literature review which is the previous related
works that have been done before. The literature review is mainly categorized into three
parts theoretical, empirical literature review, and conceptual framework. Moreover, this
chapter represents relevant information for understanding the study more.

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 CHAPTER TWO

LITERATURE REVIEW

2.1. Theoretical literature

2.1.1. Political instability

Many scholars have their interpretation and definition regarding political instability (Alesina and
Perotti, 1996) state the definition of political instability in two approaches; the first approach
emphasizes executive instability, and the second approach is based upon indicators of social
unrest and political violence. These two approaches define political instability in their ways. The
first one defines political instability as the “propensity to observe governmental changes”. The
second approach constructs an index by collecting variables and phenomena of social unrest.

(Alesina, zler, Roubini and Swagel, 1996) define political instability as the propensity of a
change in the executive power, either by constitutional or unconstitutional means. (ESONE
NDOKANG and TSAMBOU, 2015) categorize political instability into two broad dimensions
(Alesina and Perotti, 1996) but with slight differentiation and perspectives. The first includes
political unrest phenomena (political violence) such as deaths and killings under political
motivation, revolts, and revolutions. The second turn includes unforeseen and unexpected events
such as the end of a government or of an electorate that occurs either legally or by force
(government instability).

(Marrison and Stevenson 1971) cited in (Fosu, 1992) political instability defined as a situation in
which the institutionalized pattern of political authority breaks down and is replaced by political
violence, on the other hand, (Sander, 1981) cited in (Fosu, 1992) political instability categorized
in three dimensions. The first one is elite political instability involves the struggle for executive

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control and is characterized by frequent attempts to topple the incumbent of government through
non-constitutional channels or frequency of governmental collapse.

The second one is communal instability which refers to or characterized by a situation in which
communal groups, usually organized political relationships. Lastly, mass political instability
involves the use of political violence to achieve the objectives of the movement. From the above
definition’s characteristics of political instability, we can divide it into two general categories:
one with a focus on the frequency of government changes either by constitution or
unconstitutional, and the other one focus on the degree of social unrest.

Political instability as qualitative phenomena is difficult to measure quantitatively and not easily
defined. Political instability can be measured by both events and perceptions. Social and political
instability are variables that are hard to define and measure in a way that can be used in
econometric work. Political instability may bring several effects on different economic activities.
It generates doubt regarding the political and legal environment. It also disrupts market activities
and direct adverse effect on productivity. A country with having an unstable political system will
face internal and external problems. Internally factors of production will not be available
liberally because of violence, terrorism, and other evil political consequences this will bring low
final production outputs.
A country having low output couldn’t export its production to a foreign market rather than
consume it domestically. Doesn’t have sufficient consumption for the country themselves
Political instability increases uncertainty about government changes, especially in countries
where the degree of political polarization is relatively high (Younis, Lin, Sharahili and
Selvarathi, 2008). The probability of a government change may not have much effect on the
expectations of future economic policies if the next government is likely to follow policies
similar to those of its predecessors, while in highly polarized societies government changes may
lead to radical changes in policy-making hugely affecting the economic activities undertaken in
the past as well as the planned for the future economic activities.

2.1.2. Balance of payments

As per IMF Balance of Payments and International Investment Position Manual 2009 define the
Balance of Payments as a statement that summarizes transactions between residents and non-

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residents during a period. It consists of the goods and services account, the primary income, the
secondary income account, the capital account, and the financial account. It is a statistical
statement that systematically summarizes economic transactions during a specific period
(Valdivia-Velarde and Valdivia-Velarde, 2016).

Balance of payments transactions is categorized into the Current Account, Capital and Financial
Account, and reserve Assets. The Current Account records exports and imports of goods and
services, income receivable and payable abroad as well as current transfers. Current Account
transactions are recorded on a transaction’s gross basis. All credit transactions (i.e., receipts from
abroad) and debit transactions (i.e., payments to abroad) are recorded.

When all components of the balance of the payment sheet are included, it must sum to zero, and
there can be no overall surplus or deficit. For example, if a country imports more than it exports,
its trade balance will be in deficit, but the shortfall will have to be a counterbalance in other
ways- such as by funds earned from its foreign investment, by running down reserves, or by
receiving loans from other countries.

While the overall balance of the payment sheet will always balance when all types of payments
are included, imbalances are possible on individual elements of a balance of payments, such as
the current account. This can result in surplus countries accumulating hoards of wealth, while
deficit nations become increasingly indebted. Historically there have been different approaches
to the questions of how to correct the imbalance and also there have been debates on whether
these constitute an issue government should be concerned about.

An actual balance sheet will typically have numerous subheadings under the principal divisions.
For example, entries under the current account might include:
 Trade – buying and selling of goods and services.
 Exports – a credit entry.
 Imports – a debit entry.
 Trade balance – the sum of exports and imports.
 Factor income – repayments and dividends from loans and investments.

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 Factor earnings – a credit entry.
 Factor payments – a debit entry.
 Factor income balance – the sum of earnings and payments.
Different theoretical approaches try to explain the balance of payments of the current account
balance that are applied differently according to the prevailing economic environment due to the
implications on the economic policy of a nation.

2.1.2.1. Absorption Approach

The Absorption approach was introduced by (Alexander, 1952). This approach emphasizes the
fact that payments imbalances are characterized by ex-ante divergences between aggregate
income receipts and aggregate domestic expenditures (absorption). The approach shows that: a
nation's trade balance will ameliorate if its output (Y) increases by more than its absorption (A)
following exchange-rate adjustment. It concludes that unless a nation's macroeconomic variables
are affected, no balance-of-payments strategy will be effective.

The Keynesian income-expenditure identity may be written algebraically as follows

Y = C + I + G + X –M………………………………………. (2.1)
Where; Y = National income.
C = private consumption of goods and services purchased at home and abroad.
G = Government expenditure.
I = Total investment by firms and government.
X = Exports of goods and services.
M = Imports of goods and services.
Then C + I + G are combined into a single term, A, which represents domestic absorption (Total
domestic expenditure).
A = C + I + G………………………………………….……. (2.2).
Then
Y = A + X - M………………………………………………. (2.3).
By stating that national income equals absorption of the trade balance,
X –M = Y- A………………………………………………… (2.4).
It implies that from equation (2.4), it can be seen that trade balance is equal to the difference
between domestic income and total absorption. Equation (2.4) is the fundamental equation of the

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absorption approach. It can be concluded that; if the total absorption (expenditure) exceeds
income (production), then the imports will exceed exports and thus a deficit in the balance of
payment and if income exceeds absorption, the balance of payment will be in surplus.

As (GANDOLFO and GOLDBERG, 2005) illustrious the net effect is ambiguous and the
outcome of devaluation depends on its direct impact on absorption, which discourages
investment and consumption. Consequently, a reduction of domestic expenditure (absorption)
improves the current account balance. It concludes that the absorption approach proposes that
depreciation can be effective in improving the current account balances when the economy has
idle resources, the economy meets the Marshall-Lerner condition, and the government fulfills
contractionary fiscal or monetary policy along with depreciation.

2.1.2.2. Elasticity approach

This approach was primarily developed in the 1930s by Robinson cited on (Rehman and Rashid,
no date). It concentrates on the price elasticities of demand and supply for exports and imports;
the elasticities condition necessary for a devaluation to improve the trade balance components of
the balance of payments. It models the trade balance (exports and imports) by a microeconomic
approach by focusing on the choice between domestic and international goods based on the
movement along given supply and demand curves in the particular markets. It is a partial-static-
equilibrium analysis in the sense that it considers only the effect of exchange-rate variations in
the specific market for a nation's exports and imports ceteris paribus the position of the demand
curves for the exports and imports themselves being held constant.

The approach assumes that

(1) Traded goods are in perfectly elastic supply
(2) The prices are fixed in domestic currency
(3) The economy can facilely employ more resources into production for exports and imports
substitution without any barrier (Abbas Ali, Johari and Haji Alias, 2014).

The approach mainly emphasizes exchange rates, price, and income changes as the ones that
determine the current account balance. This means that the current account depends on price and
income elasticities. The quantity of a currency demanded in the foreign exchange market is

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derived from the country’s demand for imports while the supply of foreign exchange to a country
results from its exports of goods and services. The elasticities approach centers on changes in the
prices of goods and services as the determinant of a country’s balance of payments and the
exchange value of its currency.

The theory assumes that Capital flows occur only as a means of financing current account
transactions and trade balance exclusively represents the current account. The current account
balance normally adjusts through changes in the exchange rate which affect relative prices of
goods and services, thus affecting the demand both by domestic and foreign consumers. The
Marshall-Lerner (ML) condition, which states that assuming initial equilibrium condition, the
sum of price elasticities (in absolute value) of exports and imports must be greater than unity for
currency devaluation or depreciation to improve the current account balance, that is ex + em > 1,
where em is the price elasticity of import and ex is the price elasticity of export.

A depreciation or devaluation of the exchange rate makes domestic exports cheaper in foreign
markets, which increases their demand. At the same time, imports become more expensive in the
domestic market, and their demand diminishes. The net effect on the current account balance will
depend on price elasticities. If goods exported are elastic to price, quantity demanded will
increase proportionately more than the price decrease, and total export revenue will increase.

(GANDOLFO and GOLDBERG, 2005) noted that if goods imported are elastic, total import
expenditure will decrease and both cases will improve the current account balance. However,
empirical evidence indicates that goods tend to be inelastic in the short term since it takes time to
adjust to new prices, current contracts, and consumption patterns. However, depreciation of the
domestic currency is unlikely to immediately improve a country’s balance-of-payments deficit. It
is even possible that the depreciation could cause a country’s balance of payments to worsen
before it improves.

There are benefits of the elasticities approach especially when using it for empirical prediction
purposes. They proved helpful when examining short-run implications of exchange rate changes
on the trade balance. In developing countries, there are arguments that their elasticities are very

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low to satisfy the Marshal Lerner condition and depreciation worsens the Current account
balance. This is because most of them mainly import intermediate inputs and machinery for
production purposes meaning that the demand elasticity of imports is usually very low. At the
same time, demand elasticity for primary commodities exports is low.

2.1.2.3. The Monetary Approach

The monetary implication of a country’s balance of payments disequilibria (surplus and deficit)
reflects imbalances between the money demand and the supply of reserves in the economy
because of the monetization of domestic assets by the central bank. If the money demand
increases more rapidly than the supply based on the government expansion of the domestic
assets, then a nation would experience a trade and payment surplus (since the supply of goods
would exceed the demand). On the other hand, a deficit in the balance of payments results from
an excess in the money stock supplied that is not eliminated by the government (Sinyakov and
Yudaeva, 2016).
The approach assumes that
(1) The country is small, open, and under a fixed exchange rate
(2) The output and employment tend towards a full-employment situation which is determined
by real factors autonomously of monetary policy
(3) There is perfect international mobility of goods· and financial assets,
(4) Long-run equilibrium in the model requires both stock and flow equilibrium in all markets.

The theory begins by postulating that the demand for nominal money balance (Md) is a stable
function of domestic real income (yr), the domestic nominal interest rate (i), and the domestic
price level (P). The money demand is specified to be a positive function of real income and
price, and a negative function of the opportunity cost of holding money or the nominal interest
rate. Mathematically as follows
Ms = (R +D)………………………………………………………….. (2.5)
Md = F(Y, P, I)……………………………………………………..… (2.6)
Ms = Md………………………………………………………………. (2.7)
Where,
Ms = Money Supply
R = International reserve

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D = Domestic credit
Md = Money demand
Y = Level of real domestic income
I = Interest rate
P = Price level.
From equations (2.5), (2.6), and (2.7) above, we can get changes in reserves as shown below;
R = Ms – D ………………………………………....... (2.8)
Since Md = Ms in equation (2.7), then equation (2.6) is transformed as follow
R = F(Y, P, I) – D…………………………………...... (2.9)
Taking percentage changes in both sides of equation (2.9), we get
R = [Y, P, I] – D………………………………........... (2.10)
Therefore, Equation (2.10) is the reserve flow equation which concludes that;
a) Changes in reserves are the result of divergence between the growth of money demand and
growth of domestic credit.
b) With stable money demand, an increase in domestic credit will cause a decrease in
international reserves. The coefficient of D shows the extent to which changes in domestic credit
are offset by changes in international reserves.

2.2. Empirical literature

Balance of payments has numerous determinants, for many of the determinants where studies are
adopted from different academia and scholars, nevertheless, the relationship between political
instability and balance of payments are not found plentifully. As I investigated the related
researches from different sources the relationship between political instability on the balance of
payment is found negatively related.

Some studies have been done regarding the factors that affect the balance of payments
performance in different countries. Most studies focused on determinants of the balance of
payments and other studies only looked into factors that influence elements of the current
account balance. There are very few studies conducted on the relationship between the balance
of payments and political instability in very few regions. According to studies carried out in
different countries, some factors influencing the balance of payments include terms of trade,
country’s economic growth, exchange rates, net foreign direct investment, domestic inflation,

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fiscal balance, interest rate, trade liberalization, money supply, the openness of an economy and
political stability.

Balance of Payments is said to be a systematic record of all international economic transactions

during a given period, usually a year. The study of the balance of payments represents a
macroeconomic aspect of international economics. The main objective of the present study is to
consider an empirical review of political instability in sub-Saharan African countries' balance of
payments for the given year. In general, the present subtopic deals with a brief critical summary
of different scholar’s hypotheses, policy measures, and conclusions.

(Umer et al., 2010) Hypothesized balances of payment imbalance variation happen due to the
instability of political regimes among the countries. The countries which have more political
stability are enjoying favorable balances in the balance of payments. The balance of payment is a
dependent variable on political stability. They define balances such as Current account balance,
Net foreign direct investment; international reserves and external value of currency are
dependent variables on political stability.

According to (Umer et al., 2010) unquestionably acknowledged that Political stability is playing
important role in the determination of stability of the balance of payment. A stable political
regime with visionary leadership leads the nation to a higher level of a favorable balance of
payment. It makes a healthy economic environment to achieve stability of the balance of
payment. Pure theoretical macroeconomic policies cannot make macroeconomic stability unless
the country maintaining political stability. Their study has shown such as some macroeconomic
variables related to the balance of payment are healthy in selected Asian countries when the
country maintains solid political stability than economic freedom. Even though their study does
not analyze deeply, the simple model has shown that the economies, which have more political
stability, are enjoying a good balance of payment whereas the economies which have less
political stability are facing balance of payment instability.

(Lypko, 2014) states determinants of the balance of payment in comparison with Ukraine and
Poland, he argues that the Ukraine business environment is characterized by different
undesirable features like corruption, the low degree of development of the financial

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infrastructure, and political instability. This situation leads to a budget deficit and because of this
current account will deteriorate.

Political instability has a significant indirect effect on economic growth through its positive
effect on investment rates. His results also suggest that, counter to theory if political stability
increases by one unit, government spending will increase. However, it is important to note that
this negative effect that political stability has over government spending rates is more than
compensated for by the positive effect this variable has on investment rates. The non-linear
relationship between democracy and growth does not seem to exist when the sample is limited to
developing countries like Bangladesh. Government effectiveness did have a significant direct
effect on economic growth but proved to have little effect on the intervening variable
(Chawdhury, 2016).

(Baklouti and Boujelbene, 2018) determined there is a two-way relationship between democracy
and economic growth while taking into account the effect of political stability. Moreover, they
try to demonstrate that the positive effects of democracy on growth can be realized only in the
presence of a stable political framework. However, the increase of political stability and the
reduction of conflicts can reduce the government revenue, reduce poverty, and decrease the
education level. However, political instability is associated with the investor’s uncertainty about
the security of property rights, which reduce the economic growth rate.

2.3. Evaluation of the Literature

Based on studies done in the different countries regarding on balance of payment, little is known
about factors that could be influencing countries' external balance due to insufficiency of the
literature. The findings on literature such as (Baklouti and Boujelbene, 2018), (Lypko, 2014) and
(Chawdhury, 2016) indicated that political instability affects the balance of payment negatively
including other economic variables like exchange rate, foreign direct investment, economic
growth, relative income, and trade balance.

Political instability not only affects the balance of payments, but it also affects many economic
variables negatively. According to many Scholars, political instability affects economic growth
and development. A country has an unstable political system will not have desirable output this
leads to increase its import and declines its export on the contrary. As we knowing from our

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international finance study the effect of increasing import than exporting leads to deterioration in
the balance of payments. In general, the effect of political stability affects the country's balance
of payment in an orthodox way or unorthodox way.

2.4. Approach of the study and Conceptual framework

Political instability (independent variable) Balance of payments (dependent variable)

Table 2.1. conceptual framework

For this study mixed approach is chosen. Mixed methods research is an approach to an inquiry
involving collecting both quantitative and qualitative data, integrating the two forms of data, and
using distinct designs that may involve philosophical assumptions and theoretical frameworks.
The core assumption of this form of inquiry is that the combination of qualitative and

21 | P a g e
quantitative approaches provides a more complete understanding of a research problem than
either approach alone.

References
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Trade Balance: A Chronological Theoretical Review. Economics Research International, 2014,
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ALWIN, Mohammad; OQAILY, M. (2017) 'Redalyc.CURRENT ACCOUNT BALANCE,

INFLATION, INDUSTRY AND SUSTAINABLE DEVELOPMENT IN JORDAN'.

Baklouti, N. and Boujelbene, Y. (2018) ‘An econometric study of the role of the political
stability on the relationship between democracy and economic growth’, (January). doi:
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Bello-Schünemann, J. and Moyer, J. D. (2018) ‘Structural pressures and political instability:

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www.imf.org/external/np/sta/bop/bopman.pdf.

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GROWTH IN BANGLADESH Thesis’, (December).

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