Balance of Payments

• An economy’s Balance of
Payments (BOP) is official
record of its all international
transactions that took place
during certain period of time
(usually one year).

• Just like any other accounting

statement, BOP has a
particular format recommended
by International Monetary Fund
(IMF) which is used by all
countries which makes cross
country comparison easier.
 Balance of Payments

• Like World Bank, IMF is

international development
organization that provides
financial and technical
assistance to economies that
experience persistent deficits
on their BOPs.
 Surplus and Deficit

• Any international transaction

that results in Inflow of money
is recorded as Credit Entry and
it increases economy’s stock of
foreign currency reserves.

• Any international transaction

that results in Outflow of money
is recorded as Debit Entry and it
reduces country’s stock of foreign
currency reserves.
 Surplus and Deficit

• If economy’s sum of credit

entries is greater than sum of
debit entries it is known as
Surplus and if sum of debit
entries is greater than sum of
credit entries it is known as
Deficit.

Balance of Payments
• An economy’s BOP consists of 2
accounts namely Current
Account and Capital Account –
 which was previously known as
Financial Account

1. Current Account

• Trade in Goods

• Trade in Services

• Income

• Current Transfer

2. Capital Account

• Records inflows and outflow

of investments
 Balance of Payments

3. Official Financing / Official

Reserve Account

4. Net Errors and Omissions

 Trade in Goods

• Trade in Goods or Visible

Balance: records exports and
imports of tangible goods for
instance cars, electronics etc.

• Pakistan’s exports of tangible

products like wheat, fruits,
textiles will be recorded as
credit entries and imports like
cars, consumer electronics will
be recorded as debit entries.
 Trade in Services
• Trade in Services or Invisible
Balance: records exports and
imports of services – intangible
goods.

• Payment of tuition fees by a

Pakistani student to a US university
will be recorded as debit entry in
Pakistan’s Balance of Payments and
as credit entry in Trade in Services
section of US’s Current Account.

• Similarly foreign tourists visiting

Pakistan will be recorded as credit
entry in Pakistan’s BOP and

so on.
 Income
• Income: records all types of income
earned by your nationals in foreign
countries and by foreigners in your
country.

• If a Pakistani earns dividends on his

shares held in New York Stock
Exchange it will be recorded as
credit entry on Pakistan’s BOP.

• Similarly if US national earns any

income on his / her asset held in
Pakistan like a restaurant or by
working in US embassy etc that will be
recorded as debit entry on Pakistan’s
BOP and as credit entry on

US BOP.
 Current Transfers
• Current Transfers: records
unilateral transfers which are one
sided transfers and not as payment
for goods / services.

• For instance countries receiving aid

or grant. Remittances are also
recorded in Current Transfer. The
income sent back home by Pakistani
nationals working abroad is known
as remittance.
 Current Transfers

• U.S government’s grant to

Pakistani government will be
recorded as credit entry in
Pakistan’s BOP and as
debit entry in US BOP.
 Current Account
Balance
• The sum of Trade in Goods,
Trade in Services, Income and
Current Transfers make up the
Current Account Balance which
can be a Surplus or a Deficit.
 Current Account
Balance
• If the sum of credit entries
recorded is greater than the
sum of debit entries recorded in
Current Account there will be a
Surplus on the country’s Current

Account and if opposite

that would be defined as
Deficit.
 Capital Account

• All international investment

transactions will be recorded
in Capital Account.

• Investments can be classified in

2 categories namely:

Direct Investment and Portfolio

Investment which is in financial
instruments like bonds, shares
etc.
 Capital Account

• For instance if UK national

investments in Pakistan’s stock
exchange then it will be recorded as
credit entry in Pakistan’s BOP for it
is cash inflow for Pakistan and will
be recorded as debit entry in UK’s
BOP as it is cash outflow for UK.

• Similarly if Pakistani national invests

in a US company then it will be
recorded as debit entry in Pakistan’s
BOP and as credit entry in US BOP.
 Capital Account

• The income generated from

these investment in the future
are recorded in the Current
Account’s Income section.
 Surplus and Deficit
• Balance of Current and Capital
Account collectively determine any
economy’s overall position on its BOP
(Surplus or Deficit).

Current Account + Financial

Account = Change in Reserves

• If sum of Current Account and Capital

Account balance is positive – meaning
sum of all credit entries is greater
than sum of all debit entries – it is
defined as Surplus and it results in
increase in the country’s foreign
currency reserves.
 Surplus and Deficit

• Similarly if sum of Current

Account and Capital Account
balance is negative – meaning
sum of all debit entries is
greater than sum of all credit
entries – it is defined as
Deficit and results in depletion
of a country’s foreign currency
reserves.
 Net errors and
Omissions
• Any missing information
concerning that should have
been recorded in the Balance of
Payment that prevents Balance
of Payments from getting
balanced is written-off in the
Net Errors and Omissions
section.
 Net errors and
Omissions

• No matter how flawless a

countries transaction
recording system gets there
will always be some missing
information due to illegal
activities.
 Balance of
Payments
Disequilibrium

AS Economics
 Balance of
Payments
Disequilibrium
• Balance of Payments is an
official document that
records all of an
economy’s international
transactions.
• Balance of Payments
disequilibrium refers to
persistent surpluses or
deficits on economies’
Balance of Payments
 Balance of
Payments
Disequilibrium

• Persistent deficits are

indicative of economies’ lack

of competitiveness that

require implementation of

appropriate corrective actions

which we will discuss in this

lecture.
 Balance of Payments
Disequilibrium

• Similarly, economies
experiencing consistent
surpluses are likely to face
substantial appreciation of their
exchange rate which is very
likely to reduce future demand
of country’s exports.
 Relationship between
Balance of Payments
and Exchange Rates

• Exchange Rate being price of one

currency in terms of another
currency is affected by changes in
demand and supply of currencies
and so are affected by economies’
international trade transactions.

• Exchange of currencies take

place when economies engage in
international transactions and
this all is recorded on countries’
Balance of Payments.
Relationship between
Balance of Payments
and Exchange Rates
• Surplus which shows net cash
inflow in the country causes
currency’s demand to
increase which causes the
exchange rate to appreciate.

• Similarly deficit which

shows net cash outflows
causes currency’s supply to
increase which causes the
exchange rate to depreciate.
 Relationship between
Balance of Payments
and Exchange Rates

• Therefore economies facing

persistent surpluses and
deficits are likely to
experience significant
appreciation and
depreciation of their
exchange rates respectively.
 Relationship between
Balance of Payments and
Exchange Rates
• Just like economies’ position on
their BOP affects their
exchange rates, exchange rate
changes can also significantly
countries international trade
transactions.

• Exchange Rate appreciation

makes exports expensive and
imports cheaper so economies
are expected to experience
deficit on BOP.
 Relationship between
Balance of Payments and
Exchange Rates

• On the other hand,

depreciation of exchange
rates make exports cheaper
and imports expensive and
so economies are expected
to experience surplus on
BOP.
Macroeconomic Policies
to Correct BOP
Disequilibrium

• Expenditure Switching
and Expenditure
Dampening are the two
popular macroeconomic
strategies used to correct
BOP disequilibrium.
 Expenditure
Switching Policy
• Expenditure Switching policies aim
at redirecting domestic and
international expenditure away
from foreign to locally
manufactured goods / services.

• This is achieved through

imposition of different types of
protectionist policies. Trade
barriers including tariffs, quotas,
exchange controls and export
subsidies are all useful in this
regard.
Expenditure Switching
Policy
• Whereas tariffs, quotas and
exchange control discourage
imports, export subsidies artificially
boost price competitiveness of local
products increasing economy’s
export revenue.

• Unlike protectionist tools that are

quick in achieving intended aims,
export enhancing instruments are

costly for economies and are more time

consuming and therefore their results
might only be evident in medium to
longer term.
 Limitations of
Expenditure
Switching Policy
• Price inelastic demand for imports
will not reduce their quantity
demanded by large extent for a
given increase in their prices arising
from imposition of tariffs and
quotas. Hence in this case
Expenditure Switching Policy won’t
be very effective.

• Similarly export subsidies might not

be very effective in enhancing
economies’ exports because foreign
products might be more competitive
in terms of quality, durability etc.
 Expenditure
Dampening Policy

• Expenditure Dampening
Policies aim to reduce
local aggregate demand
which is expected to also
reduce demand for
imports.
 Expenditure
Dampening Policy

• When countries maintain

managed exchange rates,
excessive imports relative to
exports result in erosion of
economies’ precious foreign
currency reserves which
requires implementation of
corrective actions. Hence
constant deficits on economies’
BOP is not economically feasible
for countries.
Expenditure Dampening
Policy

Use of contractionary fiscal

and monetary policies are used
as a strategy to implement
Expenditure Dampening Policy.

• Government use of high tax

rates and lower government
spending to reduce
aggregate demand is known
as contractionary fiscal
policy.
Expenditure Dampening
Policy
• On the other hand, use of high
interest rates by Central Banks
to reduce economy’s aggregate
spending is known as
deflationary monetary policy.
 Expenditure
Dampening Policy

• Lower aggregate spending

will though adversely
affect demand of locally
manufactured
goods/services but it will
also reduce demand for
foreign products which
will limit economies’ BOP
deficits.
Strategies for sustainable
improvements in BOP
deficits
• Effective long term strategies for
maintaining favorable position on
BOP usually requires more than
Expenditure Switching and
Expenditure Dampening Policies.

• Choice of sustainable and more

effective solutions for BOP deficits
will be based on the actual cause
of deficit meaning whether it is
Current Account deficit or Capital
Account Deficit.
 Sustainable Solution for
Capital Account Deficit
• Policymakers should be
concerned about attracting more
international investment. Capital
account deficits are often
representative of low investor
confidence which results in net
investment outflow.
Improvement in economies’
investment environment will
positively affect their Capital
Account balance.
Sustainable Solution for
Capital Account Deficit

• Higher interest rates will also

encourage portfolio investment
in economy’s financial assets
which will further help
improve its BOP

balance.
Sustainable Solution for
Capital Account Deficit

• Higher relative profits,

lower cost of production
through tax holidays
and establishment of
industrial zones will
attract more FDI and
will increase economies’
capital account balance.
Sustainable Solution for
Current Account Deficit

•On the other hand,

countries suffering from
negative balances on
current account should
try enhancing their
exports’ competitiveness.
Sustainable Solution for
Current Account Deficit

• Unlike Expenditure Switching

and Expenditure Dampening
policies which are comparatively
easier to implement and have
short term impact, exports’
competitiveness can be
improved through supply-side
policies and can only be
expected to have medium to
long term

effect.
Sustainable Solution
for Current Account
Deficit
Supply-side policies are
strategies
used to enhance
economies’ production
potential.

• Improvement in
economy’s human
resource through
increased investment in
education and
professional trainings
• Interest free loans and grants
for new start-ups
• Tax holidays and
technical support for
new start-ups