CHAPTER THREE

3. THE BALANCE OF PAYMENTS

3.1. Introduction
In part one of the course, we have been dealing with the real side of the economy. In this part, we will
examine the monetary aspect of international economics. Here, money is brought in to analysis and
commodity prices are expressed in terms of domestic and foreign currency units.

The balance of payments (BOP) is a summary of statement in which all transactions of the residents of a
nation with the residents of all other nations are recorded during a particular period of time, usually a year.
An international transaction refers to the exchange of goods, services or assets between the residents of
one nation and the residents of other nations. Gifts and other forms of transfers are also included in the
nation’s BOP. The main purposes of the BOP are to inform the government about the international
position of their nation and to help it in its formulation of monetary, fiscal and trade policies. It is also
important to banks, firms and individuals directly or indirectly involved in international trade.
One cannot get each and every transaction of the nation in the BOP. The BOP, as a summary statement,
aggregates all merchandise trade in to a few major categories. Similarly, only the net balance of each type
of international capital flow is included. The question of who is the resident of the nation and who is not
the resident of the nation requires some clarification.
Residents
 Diplomats of a nation abroad
 Military personnel abroad
 Tourists
 Workers who migrate temporarily
 Corporations in a nation
Non residents
 Foreign branches of a corporation
 International institutions; UN, IMF,World bank, WTO,…
3.2. Balance Of Payments Accounting Principles
1. Credits and Debits: International transactions are classified as credits or debits. Credit
transactions are those that involve the receipt of payments from foreigners. On the other hand,
debit transactions are those that involve making of payments to foreigners. Moreover, credit
transactions are entered with a positive sign and debit transactions are entered with a negative sign
in the BOP.
Credit transactions
 Export of goods and services

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  Unilateral transfers (gifts) received from foreigners
 Capital inflow
Debit transactions
 Import of goods and services
 Unilateral transfers (gifts) made to foreigners
 Capital outflows
Capital inflows can take either of the following two forms:
An increase in foreign assets in the nation; for instance when a US resident purchases Ethiopian
stock, foreign assets in Ethiopia increases and is recorded as credit in the balance of payments.
A reduction in the nation’s assets abroad; for instance when an Ethiopian sells a foreign stock,
Ethiopian stocks abroad decrease and is recorded as credit in the BOP. Both of these transactions
involve receipts of payments from foreigners and indicate capital inflows.
Similarly, capital out flows has two forms.
A reduction in foreign assets in the nation; for instance when a US resident sells his stock in
Ethiopia, foreign assets in Ethiopia decreases
An increase in the nation’s assets abroad; for instance when an Ethiopian citizen purchases foreign
stock, Ethiopian assets abroad increase. Both of the above transactions involve making of
payments to foreigners (capital out flows) and are recorded as debit in the balance of payments.

2. Double entry book keeping: double entry bookkeeping is an accounting system used to record the
nation’s international transactions. Each international transaction is recorded twice, once as credit
and once as debit of an equal amount. This is due to the fact that every transaction has two sides;
when we sell something, we receive payment for it and when we purchase something, we make
payment for it. Example; assuming that country A is the home country and country B is the foreign
country, record the following transactions using the double entry system and prepare the BOP.
Transaction 1: exporters of A send $6000 of goods to country B, receiving in exchange of a
short term bank deposit of $6000 in country B.
Transaction 2: country A’s consumers purchase $12000 of goods from country B firms and the
payment is made by transferring $12000 to the bank account of country B firms in country A.
Transaction 3: residents of country A send $1000 of goods to country B’s citizens as a gift
Transaction 4: country A firms provide $2000 of shipping services to country B firms. Country B
firms pay these services by transferring some of their checking account deposits in country A
banks to the accounts of country A shipping firms in country A banks.
Transaction 5: country B firms send $2500 of dividends to its country A stockholders. Payment is
made by country B firm writing checks on its bank account in country A bank.
Transaction 6: citizens of country A purchase $5000 long-term corporate bond from country B.
payment is made by deducting this amount from the bank account in country A and transferring
the funds to the county A bank account of the country B firm.

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 Transaction 7: county B’s commercial banks sell $800 to country B’s central bank in country A.

The aforementioned transactions can be recorded as follows in the form of double entry system. From the
information obtained from the double entry bookkeeping, one can prepare the balance of payments for the
nation in the given year.

S.N Description Credit (+) Debit (-)

1) Goods export ---------------------------------------------------------- +$6000

Increase in short term private assets abroad ---------------------------------------------- -$6000
2) Import of goods ------------------------------------------------------------------------------ -$12000
Increase in foreign short term private assets in country A ------- +$12000
3) Export of goods -------------------------------------------------------- +$1000
Unilateral transfers ---------------------------------------------------------------------------- -$1000
4) Export of services ------------------------------------------------------- +$2000
Reduction in foreign short term private assets in country A ---------------------------- -$2000
5) Investment income receipts from abroad ----------------------------- +$2500
Reduction in foreign short term private assets in country A ---------------------------- -$2500
6) Increase in long term assets abroad --------------------------------------------------------- -$5000
Increase in foreign short term private assets in country A ----------- +$5000
7) Reduction in foreign short term private assets in country A ---------------------------- -$800
Increase in foreign short term official assets in country A ----------- +$800 _______
Total credits and debits +$29300 -$29300

The balance of payments has four categories. The summary of the international transactions is presented
based on this category in the balance of payments. These categories are briefly discussed below.
Category I: The current account
The Credit items include the following transactions.
 Export of goods and services
 Income (interest and dividends) received from investments abroad
 Wages (remittance) from workers abroad
 Unilateral transfers or gifts received from foreigners
The debit items in the current account include;
 Imports of goods and services
 Income paid to foreigners on their investment in the country
 Unilateral transfers made to foreigners
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  Remittance by foreigners in the country
Category II: Direct investment and other long term financial flows
This category is concerned with changes in holdings of long term real physical assets as well as financial
assets; where long term refers to assets with a maturity of one year or longer.
The credit items include;
 Increase in long term assets in the home country held by foreigners
 Reduction in long term assets of the home country abroad
Similarly, the debit items include;
 Reduction in long term assets in the home country held by foreigners
 Increase in long term assets of the home country abroad
Category III: Short term private (non official) financial flows
This category records transactions in short term basis; with maturity of less than one year. But, the credit
and debit entries are similar to that of category II entries.
Category IV: Change in reserve assets of official monetary authorities (central banks)
The credit items here include;
 When foreign central bank acquires assets in the home country
 When central bank of the home country sells or decreases its foreign reserve assets
The debit items include;
 When a foreign central bank sells or reduces its assets in the home country
 When the central bank of the home country increases its foreign reserve assets
Categories II to IV of the balance of payments has been called capital account in the traditional system.
However, the IMF now calls it the capital and financial account. The capital account is now being
overwhelmed by financial account and it refers to very limited and specific types of transactions such as
government international debt and migrant capital transfers (not for profit).

The balance of payments summary statement for country A

Category Amount

I. Export of goods -------------------------------------------------------------------- +$7000

Import of goods -------------------------------------------------------------------- -$12000_
Balance of trade (merchandise trade balance) ------------------------------ -$5000
Export of services ------------------------------------------------------------------ +$2000
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 Import of services ------------------------------------------------------------------ -$0____
Balance on goods and services ------------------------------------------------- -$3000
Investment income receipts from abroad --------------------------------------- +$2500
Investment income payments abroad -------------------------------------------- -$0____
Balance on goods, services and income --------------------------------------- -$500
Unilateral transfers received from abroad --------------------------------------- +$0
Unilateral transfers made to foreigners ------------------------------------------ -$1000_
Balance on current account ------------------------------------------------------ -$1500
II. Net increase (+) in foreign long term assets in country A -------------------- +$0
Net increase (-) in long term assets abroad -------------------------------------- -$5000_
Basic balance (balance on current account and long term assets) ------ -$6500
III. Net increase (+) in foreign short term private assets in country A ----------- +$11700
Net increase (-) in short term private assets abroad ---------------------------- -$6000_
Overall balance (official reserve transactions balance) -------------------- -$800
IV. Net increase (+) in foreign short term official reserve assets in country A --- +$800
Net increase (-) in short term official assets abroad ------------------------------ -$0
Statistical discrepancy ---------------------------------------------------------------- $0_
0
3.3. 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 analyze to evaluate a nation's financial standing within
international markets. Here's a description of each:

a) Current account

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

When a nation's current account is in deficit, its citizens spend more on imported goods than they keep in
savings. A current account deficit results in nation borrowing money from another to fund its deficit. Over
time, economic growth can slow if the deficit country can't get out of debt.

b) Financial account

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Is international monetary flows related to investment in business, real estate, bonds, and stocks are
documented. A country's financial account reflects the changes in its ownership of any foreign assets and
foreign ownership over its assets. The financial account is balanced when a country's ownership over
foreign assets equals other nations' ownership over its domestic assets. A deficit can develop if a country's
foreign ownership increases faster than its domestic ownership. 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.

c) Capital account

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. The capital account is usually the smallest component of the
balance of payment, and it tracks all the financial processes that don't affect a country's production,
income or savings. If a nation starts a transaction like a transfer of copyrights, trademarks or cross-border
payments on insurance premiums, it records this occurrence in the capital account. Since many economic
and financial activities nations participate in typically have direct effects on income, savings and
production, transactions within the capital account can be rare.

3.4. Balances of Trade and Disequilibrium in international transactions

When we come to the interpretation of the balance of payments, we have about six types of balances. The
first one is balance of trade (merchandise balance) and is calculated by adding the export (+) and
import (-) of goods. If this balance is found to be positive, the result is referred to as balance of trade
surplus or favorable trade balance; and if it is found to be negative, it is referred to as balance of trade
deficit or unfavorable trade balance. Country A above experiences a net debit balance of -$5000 on goods.
If we add the export and import of services to the balance of trade, we get the balance on goods and
services. Moreover, when the investment incomes (interest or dividends) received from abroad or paid to
foreigners are included to the balance on goods and services, we get the balance on goods, services and
income. Country A experiences a net debit balances of -$3000 and -$500 on goods and services and on
goods, services and income respectively.
The current account balance is calculated by adding the exports and imports of goods and services,
receipts and payments of factor incomes, and unilateral receipts and payments. Country A ha a net debit
balance of -$1500 on its current account. The current account balance is directly related to the national
income of a nation. Export of goods and services, investment income receipts and gifts received from
abroad are sources of national income. On the other hand, households, firms and governments use current
income to purchase imports of goods and services, to make investment income payments and unilateral
transfers to foreigners. From the national accounts of a nation, recall that;
Y =C + I +G+ ( X− M )………………………1
Where: Y is national income, C is consumption expenditure, I is investment spending, G is government
spending, X is export of goods and services (it includes all credit items in the current account), and M is
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import of goods and services (it includes all debit items in the current account). Rearranging the above
equation;
( X −M )=Y − ( C+ I +G )…………………….2
If (X-M) is negative (if there is current account deficit), it means that the country is spending more than its
income and living beyond its means. On the other hand, the aggregate income of a given nation is used for
either consumption, saving or paying tax. i.e.
Y =C + S+T …………………………………...3
C+ I +G+ ( X−M )=C +S +T ……………..4
( X −M )=S+ ( T −G ) −I ……………………..5
Where; S is private saving, (T-G) is government saving and I is private investment
A current account deficit [(X-M) is negative] means that the country is saving less than it invests or the
country is not saving enough.
The term “balance of payments deficit” is deficient because it lacks precision in indicating which items in
the account are being discussed. Always all items in the BOP sums to zero. The loosely used term BOP
deficit therefore refers only to some part of the BOP statement not to the entire statement. This part could
be the balance of trade, the balance of goods and services, the current account balance or any other
balance.
Balance on current account and long term assets: this cumbersome term is often shortened to the term
basic balance to emphasize the point that the first two categories of the BOP statement reflect the basic
long term forces in the economy of a nation. The current account balance reflects influences on the BOP
such as national income and its growth, spending habits and international competitiveness. On the other
hand, the long term asset flows reflect the judgments of long term investors on the relative profitability of
investing overseas rather than in the home country. Country A has a net debit balance of -$6500 on its
basic balance.
The short term private asset flows has a higher proportion in the real world because it reflects
“financing” items for transactions in categories I and II and short term financial transactions initiated on
their own. Finally, the cumulative balance after considering categories I to III is called the official reserve
transactions balance or overall balance. It reflects the net effect of all transactions with other countries
during the time period but excluding government short term financial transactions or official reserve
transactions. This balance is the one that is generally meant when economists use the broader term BOP
deficit or BOP surplus. Country A has a net debit balance of -$800 in its overall balance.
Category IV transactions measure the degree of participation or intervention by the official monetary
authorities in the foreign exchange market. For instance, the total debits exceed total credits of country A
in its overall balance resulting in a net debit balance of -$800. Thus, category IV must by itself has a value
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of +$800 to cover or settle the net balance of the previous transactions. Economists, sometimes, use the
terms autonomous items in the BOP and accommodating items in the BOP. Autonomous items in the
BOP refer to international transactions that take place in the pursuit of ordinary economic goals such as
profit maximization and utility maximization. They are undertaken independently of the state of the
country’s BOP and are reflected in categories I to III in the BOP. On the other hand, the term
accommodating items in the BOP refer to international transactions that occur because of other activities
in the BOP. They include the government (central bank) items in category IV.
Statistical discrepancy: if the total amount of credits and debits in the BOP are not balanced, there is a
need to include additional account called the statistical discrepancy. This account is required to balance
the total credits and total debits in the BOP. When total debits exceed total credits, the statistical
discrepancy will have a credit balance and vice versa. Statistical discrepancy results from incorrect
recording or from recording only one side of an international transaction.

3.5. Approaches of Exchange Rates and the Balance of Payments

In the sections, we have discussed about BOPs and exchange rate concepts in relative detail. Since,
usually, countries encounter either a balance of payments deficit or surplus; there must be a mechanism of
adjusting these imbalances to equilibrium. If monetary and fiscal approaches (policies) become unable to
do so, the final resort will be bringing equilibrium through exchange rate adjustments. To adjust (fixed or
floating) exchange rates, we also have different approaches. The chapter thus develops the relationship
between BOPs and exchange rate systems, and their adjustments. It is also devoted to a brief discussion of
the theories of capital movements.
For centuries, many countries of the world operated under a largely uniform system of fixed exchange
rates for their currencies. But the 1960s and 1970s crisis in the foreign exchange market led to reforms in
the international monetary system. This permitted nations to choose the exchange rate system most
compatible with their own economic objective. In doing so, a nation must decide whether to allow its
currency to be determined by free market forces (floating rate) or to be fixed (pegged) against some
standard of value. This section, therefore, treats these two types of exchange rate systems.

The BoP disequilibria that we saw in the previous could be adjusted in different mechanisms and in the
two exchange rate systems. The present section also discusses the various ways of bringing balance of
payments equilibrium. The important objective of this sub-section is to discuss the automatic adjustments
of the balance of payments that occur under a fixed exchange rate system. Various approaches to BOPs
adjustment will be seen.
3.5.1. Exchange Rate Adjustments

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The previous section demonstrated that BOPs disequilibria tend to be reversed by automatic adjustments
in prices, interest rates and incomes. If these adjustments are not allowed to operate, however, reversing
BOPs disequilibria may come at the expense of domestic recession or price inflation. The cure may be
perceived as worse than the disease.

Instead of relying on adjustments in prices, interest rates, and incomes to counteract payments imbalances,
governments permit alternation in exchange rates. By adopting a floating exchange rate system, a nation
permits its currency to appreciate or depreciate in a free market in response to shifts in either the demand
for or supply of the currency. Under a fixed exchange rate system, rates are set by the government in the
short–run with the adoption of devaluation revaluation over a period of time. In this section, we will see
the various ways of adjusting exchange rates. On our way, we will examine the impact of exchange rate
adjustments on the balance of payments. We will learn under what conditions currency depreciation
(devaluation) and appreciation (revaluation) will improve /worsen a nation’s payments position.

Basically, we have three approaches towards exchange rate adjustment. The first - the elasticity approach
emphasizes the relative price effects of depreciation and suggests that depreciation works best when
demand elasticities are high.

The absorption approach deals with the income effects of depreciation. The implication is that a decrease
in domestic expenditure relative to income must occur for depreciation to promote payments equilibrium.

The monetary approach stresses the effects depreciation has on the purchasing power of money and the
resulting impact on domestic expenditure levels. Let us now see each approach one by one.
a. The Elasticity Approach
Currency devaluation (depreciation) affects a country’s balance of trade through changes in the relative
prices of goods and services internationally. A trade deficit nation may be able to reverse its imbalance by
lowering its relative prices, so that exports increase and imports decrease. The nation can lower relative
prices by permitting its exchange rate to depreciate in a free market or formally devaluing its currency
under a system of fixed exchange rates. The ultimate out come of currency depreciation (devaluation)
depends on the price elasticity of demand for a nation’s imports and its exports.
What is, by the way, the price elasticity of demand? What do the various numerical values of the
coefficient indicate? In short, price elasticity of demand refers to the responsiveness of buyers to changes
in price. Mathematically,
Elasticity = % Change in Quantity Demanded = ΔQ /Q
% Change in Price Δ P/P

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The elasticity coefficient is stated numerically, without regard to the algebraic sign. If the coefficient
exceeds 1, demand is said to be relatively elastic. This means a given percentage change in price results in
a larger percentage change in quantity demanded. If the ratio is less than1, demand is relatively inelastic.
If exactly 1, it is called unitary elastic (the percentage change in quantity demanded just matches the
percentage change in price).
Let us now take an example to understand more about the elasticity approach.

Suppose the Ethiopian government decides to devalue the birr by 5 percent to correct a trade deficit with
Japan. Whether the Ethiopian trade balance will be improved depends on what happens to the yen in-
payments for Ethiopian exports as opposed to the yen out- payments for its imports. This, in turn, depends
on whether the demand for Ethiopian exports is elastic or inelastic and whether the Ethiopian demand for
Japanese imports is elastic or inelastic. Depending on the size of the demand elasticities for Ethiopian
exports and imports, Ethiopia’s trade balance may improve, worsen or remain unchanged in response to
the birr devaluation. The general rule that determines the actual outcome is the so-called Marshal-Lerner
condition.
The Marshal Lerner condition states: Devaluation (depreciation) will improve the trade balance if the
devaluing nation’s demand elasticity for imports plus the foreign demand elasticity for the nation’s
exports exceeds 1. If the sum of the demand elasticities in less than 1, devaluation will worsen the trade
balance. The trade balance will be neither helped nor hurt if the sum of the demand elasticities equals 1.
The condition may be stated in terms of the currency of either the nation undergoing devaluation or its
trading partner, but it can not be expressed in terms of both currencies simultaneously.
b. The Absorption Approach to Exchange Rate Adjustment
According to the elasticities approach, currency devaluation offers a price incentive to reduce imports and
increase exports. But even if elasticity conditions are favorable, whether the home country’s trade balance
will actually improve may depend on how the economy reacts to the devaluation. The absorption approach
provides insights into this question by considering the impact of devaluation on the spending behavior of
the domestic economy and the influence of domestic spending on the trade balance.
Dear Learner! The absorption approach starts with the idea that the value of total domestic output (Y)
equals the level of total spending. Total spending consists of consumption (C), investment (I), government
expenditure (G) and net exports (X-M.
That is: Y = C+I +G+ (X-M)
The absorption approach then consolidates C+I+G in to a single term A, which is referred to as
absorption. (X-M) is designated as B. Total domestic output thus equals the sum of absorption and the
level of net exports, or Y= A + B  B=Y-A
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This expression suggests that the balance of trade (B) equals the difference between total domestic out put
(Y) and the level of absorption (A). If national output exceeds domestic absorption, the economy’s trade
balance will be positive. Conversely, a negative trade balance suggests than an economy in spending
beyond its ability to produce. The absorption approach predicts that, if currency devaluation is to improve
an economy’s trade balance, national output must rise relative to absorption. This means that a country
must increase its total out put, reduce its absorption, or do some combination of the two.
c. The Monetary Approach to Exchange Rate Adjustment
Dear Colleague! You could easily note that the elasticity and absorption approaches of exchange rate
adjustment apply only to the trade account of the BoPs. They neglect the implications of capital
movements. It is the monetary approach to devaluation which addresses this shortcoming.
According the monetary approach, currency devaluation may induce a temporary improvement in a
nations BOPs position. Assume, for instance, that equilibrium initially exists in the home country’s money
market. A devaluation of the home currency would increase the price level (that is , the domestic currency
prices of potential imports and exports). This increases the demand for money because larger amounts of
money are needed for transaction. If that increased demand is not fulfilled from domestic sources, an
inflow results in a BOPs surplus and a rise in international reserves.
But the surplus doesn’t last forever. By adding to the international component of the home – country
money supply, the devaluation leads to an increase in spending (absorption), which reduces the surplus.
The surplus eventually disappears when equilibrium is restored in the home country’s money market. The
effects of devaluation on real economic variables are thus temporary. Over the long run, currency
devaluation merely raises the domestic price level.

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