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Made By- Vibhav Kumar Sah

Roll No. 14CO251


Course: B.Tech (Final Year)
introduction

It is an accounting statement that provides a systematic records of all the economic


transactions between resident of the country with rest of the world in the given period of
time.
Balance of payments involves the following type of economic transactions:
Trading of Visible items.
Trading of Invisible items.
Unilateral Transfers.
Capital Transfers.
Economic Transactions
1. Trading of Visible Items: Visible items means Goods which can be physically seen.
It involves exporting of goods to another country and importing of goods from
another country. It is also known as Balance of Trade.
2. Trading of Invisible Items: Invisible items means Services. All the services fall
under this category. The new technology that are transferred among countries are
also invisible items.
3. Unilateral Transfers: It means One-Sided transfers for which there is no quid pro
quo. Example- financial help received from outside, gifts related to money
received etc.
4. Capital Transfers: The capital account measures ownership transfer and financial
transactions that don't affect a country's income, production or savings.
Components of
Balance of payments
There are three components of Balance of Payments. They are:
1) Current Account: It is the most substantial part of Balance of Payment. All the
trading of visible items i.e. export and import, invisible items i.e. service provided
and unilateral transfers are put into Current Account of Balance of Payment.
2) Capital Account: It includes the following:
Debt forgiveness: Suppose a country has given a lots of debt and then decide to
cancel that debt, that will be recorded as negative in Balance of Payment because
forgiving debt means a debit itself- losing that money you should be being owed.
International death duties: a tax levied on property after the owner's death and
paid by the beneficiary.
Transfer of financial assets by migrants coming into or leaving the country.
Selling of tangible assets abroad like factory, office space.
Selling of intangible assets internationally like land, patents etc.
3) Financial Account: Financial Accounts includes the following:
Portfolio Investment: If lots of US firms decide to buy UK Government bonds, this leads to
inflow of money into UK and so it is credit for UK. Similarly, if lots of UK individuals
decide to buy US company shares, then this leads to money outflow of UK and so it is debit
for UK.
Foreign Direct Investment: Suppose German firm decides to set up shop or a factory in the
UK, well that leads to money entering into UK and so it is credit for UK. Similarly, if lots of
UK firms decide to shut down and move elsewhere to other countries well that would be
debit for UK, since it is an outflow.
Reserves: Reserves in terms of gold or currency. Any change in reserves- positive or negative
will be recorded here.
states of
Balance of Payment
Whenever economical transaction takes place, money will either inflow into the country or
outflow from the country. All the inflows are termed as credit and all the outflow are termed as
debit.
1. Deficit State: A balance of payments deficit means the country imports more goods,
services and capital than it exports, so net money is outflowing out of the country. Here
Debit > Credit.
2. Surplus State: A balance of payments surplus means the country exports more than it
imports, so net money is inflowing into the country. Here Debit < Credit.
3. Balance State: A balance of payment is said to be balanced when total inflow is equal to
total outflow, that is no net flow of money. Here Debit = Credit.
Autonomous and Accommodating
Transactions

1. Autonomous Transactions: Economic Transactions are said to be Autonomous transactions when


transactions are made independently of the state of the state of Balance of Payment i.e. for
maximisation of profit. These items are called above the line items in the Balance of Payment.
2. Accommodating Transactions: Economic Transactions are said to be Accommodating transactions
when transactions are made to maintain balance in Balance of Payment. These are called
compensating capital transactions. These transactions take place to make debit equal to credit.
What causes Deficit in
Balance of Payment?
1) Development Activities: Developing countries often need to import a huge amount of technology
from developed countries fro their development, this leads to net outflow of money.
2) High Rate of Inflation: Suppose we get a mobile cheaper in foreign countries than in our country
due to high rate of inflation, then definitely we prefer to buy it from foreign countries thus causes
money to outflow.
3) Strong Domestic Growth: When there is strong domestic growth, it means incomes of people are
high, their standards of living are high and they are willing to buy more imports to improve their
material standards of living and it happens that lots of that stuff are not made in that country so they
need to import a lot thus causing a deficit in Balance of Payment.
4) Recession Overseas: If there is a recession overseas, it means income abroad are falling so the
demand for exports is going to reduce. If the demand for exports fall, then revenue generated from
export is going to decrease and money inflow decreases and causing deficit in Balance of Payment.
1) Political Disturbance: Suppose one Government says to import only goods from
other countries. The next Government which will come will say to import both
goods and services, thus increases huge outflow of money and causes deficit to
Balance of Payment.
2) Change in Preference: Suppose we import item1 from one country after sometime
we realise we dont like that item and then we move on to item2, and we start
importing item2 from another country, then this change in preference leads to huge
outflow of money in order to buy item1 and item2, thus causes deficit in Balance of
Payment.
3) Decrease in Export: Decrease in export decreases net inflow of money into the
country thus decreases credit. This decrease in export may be caused because
exporting of goods has become expensive.
4) Increase in Import: Increase in import increases net outflow of money of the
country thus increases debit. This increase in import may be caused because
importing of goods has become cheap.
5) Depletion of natural resources: If a country is exporting a natural resource to a
foreign county, then depletion of that natural resource would cut down the revenue
the country has been earning so far thus inflow to money decreases.
6) Low investment, low productivity and poor quality of goods make export of a
county less competitive to other countries foreigner would buy from other
countries.
Consequences of Deficit in
Balance of Payment
Aggregate Demand: Aggregate demand is the total demand of a countrys goods and services at a
given price level in a given time period. It is a measure of total expenditure on a countrys good and
services. Mathematically, it is expressed as:
AD = C + I + G + (X - M)

where AD = Aggregate Demand


C = Consumer Spending
I = Investment by Private Firms
G = Investment by Government
X = Export
M = Import

When imports are higher than exports, then (X-M) becomes negative and this causes AD to decrease.
When AD decreases, so according to graph we can say GDP of a country decreases.
Decrease in Exchange Rate: If a country is importing more than its exporting i.e.
selling more of its currency to buy foreign goods and foreign assets than it is
selling to the rest of the world then overall the supply of its currency in the global
market will be increasing and that will shift the supply of the currency towards the
right in the graph. From this we infer that the price or the exchange rate of the
currency of that country will come down.

If the deficit is large and the economy is not able to attract enough inflows of
foreign investment, then their currency reserves will dwindle. There may come a
time when the country needs to seek emergency borrowing from institutions such
as the International Monetary Fund, that may lead to external debt.
What is the remedy?
So if we have these serious issues with the deficit in Balance of Payment, then there should be some
remedy too. All countries need to maintain a balance between the countrys deficit and surplus to
avoid these serious problem. If a country is experiencing a large current account deficit, then they
will often record a financial account service which balances the entire account. But how it can be
done? Lets take an example and understand it.

Suppose there are two countries- USA and China. Let USA has got large current account deficit and
China has got large current account surplus, so this is not balanced. For this USA needs to have
financial account surplus. So China which is in position of current account surplus is simply sitting
on lots and lots of excess cash since they are selling more to the rest of the world their Chinese
products than they are actually buying from the rest of the world
implying they have a massive reserve of cash that can be used to invest in a country where
investment is safe and secure and give a good rate of return so China will buy USA
Government bonds and shares and would even set up lots of factories in USA thereby
enhancing money inflow into the USA and props up the financial account for the USA. This
money outflow from China would cause financial account deficit to China. Both ways-
USAs current account deficit and financial account surplus and Chinas current account
surplus and financial account deficit are going to balance each other respectively. Thus credit
becomes approximately equal to debit and establish a balance in Balance of Payment.

Just in case financial account and capital account cant balance the capital account deficit, we
have another part- net errors and omission part of the account where the accountants get
together and they fill in the numbers to make sure that the overall account does balance, the
overall spreadsheet sums to be zero as it needs to be balanced. No country can owe money to
the rest of the world for a long time and that money has got to come from somewhere. Hence
net errors and omission part is also called Balancing Tool.

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