Balance of Payments

As a child, you must have often seen your parents settling accounts

and keeping tabs on small expenditures. You must have seen them set

aside reserves, keep a record of all transactions and purchases, and

tally their accounts and statements to ensure they are all set for the

month or the quarter. Now apply this scenario to the country as a

whole. And that’s Balance of Payments in layman terms.

Balance of Payments

The Balance of Payments or BoP is a statement or record of all

monetary and economic transactions made between a country and the

rest of the world within a defined period (every quarter or year). These

records include transactions made by individuals, companies and the

government. Keeping a record of these transactions helps the country

to monitor the flow of money and develop policies that would help in

building a strong economy.

Browse more Topics under Open Economy Macroeconomics

● Exchange Rate

● International Experience of Exchange Rate Systems

● National Income Identity for Open Economy

● Trade Deficits, Savings and Investments

In a perfect scenario, the Balance of Payments (BoP) should be zero.

That is, the money coming in and the money going out should balance

out. But that doesn’t happen in most cases. A country’s BoP statement

correctly indicates whether the country has a surplus or a deficit of

funds. A BoP surplus indicates that a country’s exports are more than

its imports. A BoP deficit, on the other hand, indicates that a country’s

imports are more than exports. Both scenarios have short-term and

long-term effects on the country’s economy.

Components of BoP

Now let’s understand the different components of the BoP. The BoP

consists of three main components—current account, capital account,

and financial account. As mentioned earlier, the BoP should be zero.

The current account must balance with the combined capital and

financial accounts.

Explore more under Balance of Payments

Open-Economy Macroeconomics

● Trade Deficit, Savings, and Investments

● International Experience of Exchange Rate Systems

● National Income Identity for Open Economy

● Exchange Rate

Current Account

The current account monitors the flow of funds from goods and

services trade (import and export) between countries. Now this

includes money received or spent on manufactured goods and raw

materials. It also includes revenue from tourism, transportation

receipts, revenue from specialized services (medicine, law,

engineering), and royalties from patents and copyrights. In addition,

the current account includes revenue from stocks.

Capital Account

The capital account monitors the flow of international capital

transactions. These transactions include the purchase or disposal of

non-financial assets (for example, land) and non-produced assets. The

capital account also includes money received from debt-forgiveness

and gift taxes. In addition, the capital account records the flow of the

financial assets by migrants leaving or entering a country and the

transfer, sale, or purchase of fixed assets.

Financial Account

The financial account monitors the flow of funds pertaining to

investments in businesses, real estate, and stocks. It also includes

government-owned assets such as gold and Special Drawing Rights

(SDRs) held with the International Monetary Fund (IMF). In addition,

it includes foreign investments and assets held abroad by nationals.

Similarly, the financial account includes a record of the assets owned

by foreign nationals.

Why is BoP important?

The BoP statement provides a clear picture of the economic relations

between different countries. It is an integral aspect of international

financial management. Now that you have understood BoP and its

components, let’s look at why it is important.

To begin with, the BoP statement provides information pertaining to

the demand and supply of the country’s currency. The trade data

shows a clear picture of whether the country’s currency is appreciating

or depreciating in comparison with other countries. Next, the

country’s BoP determines its potential as a constructive economic

partner. In addition, a country’s BoP indicates its position in

international economic growth.

By studying its BoP statement and its components closely, a country

would be able to identify trends that may be beneficial or harmful to

the economy and take appropriate measures.

Exchange Rate

Exchange rate quotations can be quoted in two ways – Direct

quotation and Indirect quotation. Direct quotation is when the one unit

of foreign currency is expressed in terms of domestic currency.

Similarly, the indirect quotation is when one unit of domestic currency

us expressed in terms of foreign currency. Let us learn in more detail

about Exchange rate, Direct, and Indirect quotations.

Direct and Indirect Quote

Let’s now look at it in detail. In financial terms, the exchange rate is

the price at which one currency will be exchanged against another

currency. The exchange rate can be quoted directly or indirectly.

The quote is direct when the price of one unit of foreign currency is

expressed in terms of the domestic currency.

The quote is indirect when the price of one unit of domestic currency

is expressed in terms of Foreign currency.

Since the US dollar (USD) is the most dominant currency, usually, the

exchange rates are expressed against the US dollar. However, the

exchange rates can also be quoted against other countries’ currencies,

which is called as cross currency.

Now, a lower exchange rate in a direct quote implies that the domestic

currency is appreciating in value. Whereas, a lower exchange rate in

an indirect quote indicates that the domestic currency is depreciating

in value as it is worth a smaller amount of foreign currency.

Browse more Topics Under Open Economy Macroeconomics

● Balance of Payments

● Exchange Rate

● International Experience of Exchange Rate Systems

● National Income Identity for Open Economy

● Trade Deficits, Savings and Investments

Base and Counter Currency

Now that you understand the concept of the direct and indirect quote,

let’s look at some other related concepts. The exchange rate has two

components—the base currency and the counter currency.

In a direct quotation, the foreign currency is the base currency and the

domestic currency is the counter currency. In an indirect quotation,

it’s the other way around. The domestic currency is the base and the

foreign currency is the counter.

For example, USD to INR is a direct quote and INR to USD is an

indirect quote. Most exchange rates list the USD as the base currency.

Exceptions, in this case, include the Euro and the Commonwealth

currencies such as Great Britain Pound (GBP), Australian Dollar

(AUD), and the New Zealand Dollar (NZD).

Exchange Rate Types

Floating and Fixed Exchange Rate

Exchange rates do not remain constant. They can be floating or fixed.

The exchange rate is considered to be floating when the currency rate

is determined by market conditions. Most countries use a floating

exchange rate. On the other hand, some countries prefer to fix their

domestic currency as against a dominant currency, such as the USD.

Spot and Forward Exchange Rate

Exchange rates can also be classified into two types, namely spot, and

forward exchange rates. The spot exchange rate is the current

exchange rate at any given point in time. The forward exchange rate

refers to the exchange rate that is stated and traded upon as of today

but earmarked for payment and delivery at a future date.

Learn about National income identity for the open economy here.

Foreign Exchange Market

(Source: Wikipedia)

Know more about International Experience of Exchange Rate Systems

So, who determines the foreign exchange rate? The exchange rates are

settled at the foreign exchange market, which is a decentralized

market where currencies are bought, sold, and exchanged at current or

fixed upon prices. The foreign exchange market is open 24 hours a

day except for the weekends. The buying rate is the rate at which the

money dealers will buy a currency and the selling rate refers to the

rate at which they will sell a currency.

These quoted rates will usually accommodate the dealer’s profit

margin. The foreign exchange rates don’t always remain the same.

They are prone to fluctuation when the value of either of the

two-component currencies in a currency pair changes. Currencies can

become valuable or depreciate in value when the demand and supply

factors change.

Solved Example for You

Q: Identify the indirect quote from the following options.

a. CAD to USD

b. USD to CAD

Ans: The correct answer is option ‘a’. The indirect quote is the

Canadian dollar (CAD) to US Dollar (USD)

International Experience of Exchange Rate Systems

During your visits to a bank or a financial institution, you may have

noticed a special counter for foreign exchange services. You may have

also observed an LED screen or a notice board displaying the

exchange rates for various currencies. So, who determines these rates?

Well, this is where exchange rate systems come into play. Let us know

what fixed exchange rate is.

Exchange Rate

Usually, exchange rates change based on the demand and supply of a

currency. If you want to travel abroad, you will have to exchange your

currency with your destination’s currency. This will create a demand

for that foreign currency. In addition to demand and supply,

governments also influence exchange rates. Let’s look at some basic

exchange rate systems and how they affect the market.

(Image Source: Wikimedia)

Free-Floating System

In this system, currency values are purely determined by demand and

supply factors in the foreign exchange market. A floating exchange

rate is the currency rate between two currencies at any given time.

Governments and banks do not influence the currency values in this

case.

Let’s now understand how this affects a country’s trade. If a country’s

currency value depreciates against other currencies, it means that they

will have to pay more for imported goods. Consequently, the imported

goods become more expensive. In such a case, buyers will shift to

domestic goods. And the demand for the same imported goods will

decrease, which converts the country’s balance of trade to a surplus.

This surplus then increases the domestic currency’s value as against

other currencies in the foreign exchange market.

One of the advantages of a floating exchange rate system is that it is

self-regulating. The exchange market by itself controls any major

changes in demand and supply. However, this system’s disadvantage

is that it is unpredictable. While trading, buyers and sellers from

different countries will have to also consider exchange rate

fluctuations.

Managed Float System

In a managed float system, governments and banks occasionally

participate in the trade of currencies in a bid to control the price of

their currency. This may happen only when the governments of

countries that follow a free-floating exchange rate system want to

prevent sudden major swings in the value of their currencies.

For instance, if a currency’s value is increasing rapidly and there is a

consequent reduction in exports, then that country’s government may

then intervene to reduce its currency’s value to ensure that the trade is

not affected.

Fixed Exchange Rate

Now, let’s take a look at the fixed or ‘pegged; exchange rate system.

In this system, the government or the central bank of a country fixes

the official exchange rate of its currency against another country’s

currency or against gold. This system helps in stabilizing a country’s

currency value and maintain low inflation rates. In the fixed exchange

rate system, the central bank or the government of a country will buy

or sell its own currency in return for the foreign currency it fixes the

value to in the foreign exchange market.

The advantage of this system is that a country can remove the

unpredictability factor providing more opportunities to its importers

and exporters. Following a fixed exchange rate system would help in

keeping the exchange rate steady. However, it would require the

country to maintain large reserves of the foreign currency it pegs its

domestic currency’s rate too. A disadvantage of the fixed exchange

rate system is that the country will not be able to adjust its interest

rates as needed.

Solved Example for You

Q: In which exchange rate system is the currency rates influenced by

demand and supply factors?

a. Free-Floating

b. Fixed

c. Managed Float

Ans: The correct answer is option “a”. Demand and supply factors in

the foreign exchange market determine currency values in a

free-floating exchange rate systems.

National Income Identity for Open Economy

Now we all know about the imports and exports of goods, right?

Increasing foreign exchange of goods and services is extremely

beneficial to the country’s wealth. Here, let us learn about National

Income Identity for an Open Economy and how GDP is a great

international indicator of a country’s economy.

National Income Identity

(Source: Tradingeconomics.com)

A healthy economy thrives on good trade relations. Today, a lot of

countries have an open economy where there are no trade restrictions.

An open economy refers to an economy where people and businesses

can freely trade in goods and services with other countries. There are

several benefits of an open economy. With increased trade, people

have a wide variety of goods and services to choose from.

They can choose to invest their money abroad. International trading is

not restricted to just goods and services alone. An open economy

presents innumerable opportunities for global investments and

technological advancements as well. With increased trade and

economic growth, what improves is the Gross Domestic Product

(GDP) of the economy.

Let’s now understand how GDP works. In an open economy, the GDP

is the market value of all finished goods and services produced in a

country within a specific period of time. There are several approaches

to calculating the GDP. The most common approach is the

expenditure approach that divides the GDP into household

consumption (C), investment (I), government purchases (G), and net

exports (NX). Hence, you can express GDP as follows:

GDP or Y = C + I + G + NX

This expression of GDP is called the national income identity for an

open economy. Let’s look at each component of the expression in

detail.

Browse more Topics under Open Economy Macroeconomics

● Balance of Payments

● Exchange Rate

● International Experience of Exchange Rate Systems

● Trade Deficits, Savings and Investments

Consumption

Consumption refers to the household consumption of goods and

services produced domestically. It includes expenditure on durable

goods (home appliances, jewellery, books), non-durable goods (food,

fuel, medicines), and services (medical care or education).

Investment

The investment component in the national income identity refers to

capital expenditure or investment on new capital for producing

consumer goods. It does not include the exchange of existing assets

and purchase of shares and bonds. Investment involves capital that can

be used in the future.

The purchase of a new house by a family can be considered as an

investment (for calculating GDP). However, you cannot consider

investment in financial products with the intent of savings as an

investment (in terms of calculating GDP). Another example would be

that of a factory or company that invests in new equipment or

software.

Government Purchases

The government purchases component refers to the total expenditure

by the federal, state, or local governments on final goods and services.

For instance, public sector salaries and purchase of military equipment

and medicines would be categorized as government purchases.

Government purchases do not include transfer payments (subsidies,

social insurance, medical insurance), pensions, or unemployment

benefits as there is nothing earned in return.

Net Exports

Net Exports refers to the difference between the total imports and

exports, that is the difference between the value of goods and services

exported to other countries and value of goods and services imported

from other countries.

Now that you are familiar with GDP and national income identity,

let’s try and understand why imports are deducted from the identity.

Remember net exports (NX)? Imports have to be deducted from the

identity because imports, in most forms, are usually included in the

consumption, investment, and government purchases components.

Hence, the imports must be subtracted to correctly calculate the value

of domestic goods and services.

Let’s look at an example. When you purchase an electric appliance

that is imported from another country, it is still categorized as a

household consumption. Similarly, if a company imports a piece of

equipment and then uses it to produce and export a finished product,

then that value is included in the domestic exports. Thus, if imports

are not deducted, the GDP would be incorrect.

Let us learn in detail about the Exchange rate.

Solved Question for You

Q: Which formula correctly represents the national income identity for

an open economy? or Y =

a. C + I + NX

b. I + NX + G

c. C + I + G + Ex

d. C + I + G + NX

Ans: The correct answer is option ‘d’. The national income of an open

economy includes consumption, investments, government purchase

and net exports.

Trade Deficit, Savings and Investments

You must have often heard politicians and economists talk about the

growing trade deficit of our country. They always seem extremely

concerned by it. What is this trade deficit and why is it such a

headache for the government? Come let us take a look.

Trade Deficit

A healthy balance of trade plays an important role in sustaining the

economy of a country. And a country’s savings and investments play

an important role in maintaining this balance. But there are times

when the balance of trade tilts towards a trade surplus or a deficit. A

trade deficit occurs when a country’s total imports exceed its exports.

A trade surplus, on the other hand, occurs when a country’s total

exports outweigh its imports.

So trade deficit represents a negative balance of trade. However, it is

not exactly harmful to the economy. When do imports increase? They

increase when a country’s production of domestic goods and services

is not enough to meet the local demand. Imports also increase when

the consumers’ purchasing power increases to create a demand for

expensive foreign products.

In such a case, a trade deficit then provides opportunities for domestic

businesses to produce quality goods and services to match foreign

products. With domestic products available at lower prices, the

inflation rate decreases. And a market with a wide variety of both

domestic and imported goods provides the element of choice to the

consumers. In such a case, an increase in imports indicates a fast,

growing economy. And a growing economy attracts more foreign

investment.

However, a trade deficit, in the long run, may not be beneficial. And

that’s where a healthy balance of imports and exports is required.

When imports increase beyond a certain extent, prices of goods and

services reduce due to high competition. Consequently, domestic

companies are not able to manufacture and produce goods at such low

prices. As a result, employees lose jobs and companies manufacture

fewer goods and services. The dearth of domestic goods and services

results in more imports and as a result, more trade deficit.

Savings and Investments

(Source: Pixabay)

Next, let’s look at savings and investments. Both terms are closely

related and important in macroeconomics. In generic terms, savings

refers to money left over after accounting for expenses. People

generally use the term “savings” interchangeably with “investments”.

But it is quite different. While savings is the excess income after

expenditure, investment is the money earmarked or intended for

conversion into capital. Savings do not involve risks. On the other

hand, investments are subject to a certain amount of risk.

In economic terms, the savings and investments balance (I = S) refers

to the balance of national savings and national investments, which is

equal to the current account. According to the Keynes theory, an

economy is in equilibrium only when saving is equal to investment.

When savings translate into investments, capital is generated. And

during trade deficits, this capital is of utmost importance as it drives

economic growth.

An increase in savings doesn’t always indicate an increase in

investments. This is where the equilibrium comes into play. Savings

should be deposited into intermediaries like banks and financial

institutions so that they can be converted into investments for

business. An increase or decrease of savings as against investments,

again, has long-term and short-term effects on the economy.

When an economy faces a trade deficit, the balance of savings and

investments becomes all the more important. We already discussed

that a trade deficit isn’t always detrimental. However, if a country has

enough savings and investments, then it can offset its deficit using

those savings.

Solved Examples for You

Q: Identify whether the following statement is true or false.

“Trade deficit is always harmful to a country’s economy.”

1. True

2. False

Ans: The correct answer is option “b”. Trade deficit may actually be

beneficial in the short run since it indicates higher imports due to

consumer consumption. This, in turn, brings down inflation.