Professional Documents
Culture Documents
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.