Open Economy and

Balance of Payments
Dr. Tarun Das, Professor,
IILM

BOP by Tarun Das 1

 Contents
1. Macroeconomic balance sheet in an open
economy and two gap theory
2. Macroeconomic balance sheet in an open
economy and Three gaps theory
3. Numerical example on Three Gaps
4. Balance of Payments (BOP)
5. Numerical Question on BOP

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 1. Macroeconomic Balance
and Two-Gap Theory

Y=C+I+X–M (1)
Y=C+S (2)
Where, Y = Income, C = Consumption
I = Investment, S = Savings
X = Exports, M = Imports
Equating equations (1) and (2) we get
C+I+X–M=C+S
(I – S) = (M – X) (3)
Investment-Savings gap (or Resource
Gap on the domestic account) equals
current account surplus.
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 2.1 Macroeconomic balance sheet
in an open economy
Y = GNP = GDP + NFI (4)
GDP=(PubExp+PubInv+PvtExp+PvtInv+X–M) (5)

Where
GNP = Gross national product
GDP = Gross domestic product
PubExp = Public expenditure
PubInv = Public investment
PvtExp = Private expenditure
PvtInv = Private investment
X = Exports of goods and services
M = Imports of goods and services
NFI = Net factor income from abroad

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 2.2 Three Gaps Theory
Rearranging the terms of equations (4) and (5)
we get
 Y = (PubExp + PubInv + PvtExp + PvtInv + X –
M) + NFI (6)
or, Y – (PvtExp + PvtInv) =
(PubExp + PubInv) + (X – M + NFI) (7)
or, Y – (PvtExp + PvtInv + T) =
(PubExp + PubInv - T) + (X – M + NFI) (8)
Or, (X – M + NFI) = [Y – (PvtExp + PvtInv + T)]
+ [T – (PubExp + PubInv)]

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 2.3 Three Gaps Theory
(X – M + NFI) = Current account balance =
Exports of goods and services minus imports of
goods and services plus net factor incomes from
abroad
Y – (PvtExp + PvtInv + T) =
Private sector balance = Income minus private
expenditure minus private investment minus
taxes paid to the government
T - (PubExp + PubInv) = Public sector balance
= Taxes minus Public expenditure minus public
investment

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 2.4 Three Gaps Theory

Thus we get

Current account balance =

Private sector balance +
Public sector balance

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 3.1 Workout Session: The following
data relate to Indian economy for the year
2003-04.
Items (Rupees
billion)
1.GNP 27459
2.Public Expend (PubExp) 3121
3.Private Expend (PvtExp) 17353
4.Public Invest (PubInv) 1802
5.Private Invest (PvtInv) 5680
6.Public savings (PubSav) 284
7.Private savings (PvtSav) 7695
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 3.2 Workout Session: The following
data relate to Indian economy for the year
2003-04.
Items (Rupees
billion)

8.Taxes less subsidies (T) 2402

9.Exports of goods & services (X) 4078

10.Imports of goods and services 4434

(M)

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 3.3 Workout Session: Question
Given above data, estimate the
following:
1. GDP at current market prices
2. Net factor income from abroad
3. Current account balance
4. Private Investment-Savings gap
5. Public Investment-Savings gap
6. Overall Investment-Savings gap
7. Private account balance
8. Public account balance
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 3.4 Numerical Question
9. Examine the following identities:
(a) Overall Investment-savings gap
(or resource gap on the domestic
account) equals current account
balance (CAB)
(b) Current account balance equals
private sector balance plus public
sector balance

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 4.1 Balance of Payments
Accounting
A. Current Account – Account is closed by the end of the
year. These are non-asset transactions and have no
future obligations.
B. Capital Account- Account is not closed within a year
and have future obligations. It consists of financial
flows which can be grouped into debt flows and non-
debt creating financial flows. Debt has attendant
obligations for repayment of principal (amortization)
and payment of interest charges. Amortization
appears on capital account while interest charges
appear on current account. Similarly non-debt
financial flows appear on capital account, while
dividends, royalties etc. appear on current account.

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 4.2 Current Account
A.1 Trade Account –
Trade balance = Merchandise exports minus
merchandise imports
A.2 Invisibles Account- A.2.1 to A.2.4
A.2.1 Non-factor services = Travel +
Transportation + Insurance + Govt not
included elsewhere + Miscellaneous
business and professional services
(including software, BPO etc.)
A.2.2 Factor
incomes(interest,rent,dividend,wage)
A.2.3 Private transfers (remittances)
A.2.4 Official transfer (foreign grants)
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 4.3 Capital Account
B.1 Non –debt creating financial flows
B.1.1 Foreign Investment = Foreign Direct
Investment (FDI) + Portfolio Investment
B.2 Debt Flows- B.2.1 to B.2.5
B.2.1 External Assistance = Loans obtained
from multilateral organizations and
bilateral countries
B.2.2 External Commercial Borrowing
B.2.3 Short-term credits (trade credits)
B.2.4 Banking capital (deposits and others)
B.2.5 Other capital

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 5.1 Workout Session: The following
data relate to Indian BOP in 2005-06
Items US$ Billion

1 Merchandise Exports f.o.b. 104.8

2 Merchandise Imports c.I.f. 156.3
3. Net travel services 1.4
4. Net transportation services -1.2
5.Net software and other non- 22
factor services
6. Inward FDI flows 7.7
7. Outward FDI flows 2.0
8. Net Portfolio investment 12.5
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 5.2 Workout Session: The following
data relate to Indian BOP in 2005-06
Items US$ Billion

9.Factor incomes, net -5.6

10.Private transfers, net 24.1
11.Official transfers, net 0.2
12.External assistance, net 1.4
13. Ext. comm. borrowing, net 1.6
14. Short-term credit, net 1.7
15. Banking capital, net 1.4
16. Other capital flows, net 1.4
17. Foreign exchange reserves
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at the beginning of the year

 5.3 Workout Session: Question on
BOP
A. Given above data, estimate the
following for Indian BOP in 2005-06:
1. Trade balance
2. Non-factor services balance
3. Net invisibles
4. Current account balance
5. Total foreign investment
6. Total capital flows
7. Overall balance of payments
8. Foreign exchange reserves at the year-
end

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 Thank you
Have a Good Day

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