of Payments: M ea nin g

,_i,11Ce y any coun . .

the rnodern wo rld, there is hardl ed s. Ev ery co ! w~ tch ts sel f-sufficient in _the sense tha t it
it ne
. ~ces all the goods and servicesun
111
try or ca n be d try im po rts from other countries the goods tha
t
rv-ot be produced at all inila the co as compared
pro uced only at an unduly high cost

., tb~:
c,nn rei supplies. Sim
~ u•
p: fe r to bu y fro m ab
en
r!

ts
!a

is
a

a
d
co
ra'

sys
:e?

tem
ihe

t
xp

·
ort sdt o oth
an pro uce at home.
on
er countries the [Link]

d oif economi•c transactions of the residents of a

those

''The .balance of pa ym . a le rec

en pe rio d oif tim e •"T he record 1s · so prepared as to provt·de
du nn ga giv
-mtry wzth the rest ofthe thwo rld. try 's ex ter na l eco nomic transactions. Thus
p,t<' "
mpon en ts of a co un
ineanin~and measure to e va no us corec eip ts an d pa ym en ts on account of goods exported, ser
vice~
t of al!
!be aim 1s to pres~nt an a~ co un a co un try , an d goods imported, services receiv
ed and
res ide nts of
rendered and capital rec ~iv ed by . Th e ma in pu rpo se of keeping these records is to know
co un try
capital transferred by res ide nts of the an d to he lp the Go ve rnm ent in reaching decisions
of the co un try
the international ec on om ic po sit ion an d tra de and payments questions on the oth
er.
on the on e ha nd ,
on monetary and fis ca l po lic ies
of Pa yments
Balance of Trade and_Balance
en ts are tw o rel ate d ter ms bu t they should be carefully
pa ym
Balance of tra de an d ba lan ce of ly the sam e meaning. Balance of trade
us e the y do no t ha ve ex act
distinguished from ea ch oth er be ca co mm odities only, i.e., visible items on
ly.
im po rts an d ex po rts of
refers to the difference in va lue of ibl e tra de because the movement is open an
d
tri es is kn ow n as vis
Movement of go od s be tw ee n co un
ici als .
ran be verified by the cu sto ms off the
the ex po rts an d im po rts ma y be exactly equal, in wh ich case,
Dwing a giv en pe rio d of tim e, no t necessary, for those wh~ ex
port
id to be ba lan ce d. Bu t thi s is
balance of payments of tra de is sa the va lue of ex ports exceeds the value ~f un po
~,
me pe rso ns . If
and import are no t ne ce ssa ril y the sa ou rab le ba lan ce of tra
th
de . If e value of its
ex po rt su rp lus or a fav
die country is sai d to ex pe rie nc e an d to have a deficit or an adverse
balance
ex po rts , the co un try is sai
imports exceeds the va lue of its
· the
ef~ade . ,,d · d fr the mercantilist writers of ha d
ld If Ind ia
18
Th
e terms "fa vo ur ab le" an d "u nfa vo ur ab le are
eig n
en
tra
ve
ns ac
.
tio
om
ns we re :
d .
efm !:ts .
India would ~
res wo r: !d ed ~ wealth an
of the for
th century. In tho se da ys , se ttl em en ts rte d ~ SO cro
d:
s bu t ha d im po
~r ted f l 00 cro res wo rth of go od co un tn~ s: As ~old wa sard !d exports surplu
s ~ ';'
fro m the for eig n
~thtve ' 20 cro res wo rth of go ld we alt hy , the me rca nti hs t wn ter s reg
~-
~
L , e receipts of go ld ma
de a co un try
·
0
~
uctng f:
avourable to the co un try . ~ .
717 I
•~)
 118
Macroeconomics : Theory and Policy
On the other hand, if India had exported t 100 crores worth o f ~, b u t ~ ' 150
crores worth of goods, it had to pay ~ 50 crores in gold to the foreigners. India would be losmg gold
and would be poorer to that extent. Therefore , an import surplus was ~ by e mercantilist
th
writers as adverse balance. But in these days, the international transactions are not settled in
terms of gold. Even then, the tenns "favourable" and "unfavourable" balance of trades have [Link]
to be used till today.
Exports and imports of a country are rarely equal. Balance of trade, in other words, will not
balance. During any period a country may experience a favourable or an adverse ba_lance of trade.
Distinction between Current Account and Capital Account
The distinction between the current account and capital account may be noted. The current
account deals with payment for currently produced goods and services; it includes also interest
earned or paid on claims and also gifts and donations. The capital account, on the other hand, deau
with payments ofdebts and claims. The current account of the balance of payments affects the level
of national income directly. For instance, when India sells i_ts currently produced goods and servicea
to foreign countries, the producers of those goods get income. In other words, current account
receipts have the effect of increasing ·the flow of income in the country. On the other hand, when
India imports goods and services from foreign countries and pays for them, money which would
have been used to demand goods and services within the country flows out to foreign countries. The
current account payments to foreigners involve reduction of the flow of income within the country
and constitute a leakage. Thus, the current account or trade account of the balance of payments has
a direct effect on the level of income in a country. The capital account, however, does not have such
a direct effect on the level of income; it influences the volume of assets which a country holds.
It may be further poted that when there is a deficit in the current account, it has to be fina!)Ced
either by using foreign exchange reserves with Reserve Bank of India, if any, or by capital inflows
(in the form of foreign assistance, funds flowing through FDI and portfolio investment by Fils,
commercial borrowing from abroad, non-resident deposits).
Determinants of Balance of Payments
There are several variables which determine the balance of payments position of a country,
viz., national income at home and abroad, exchange rate of national currency, the prices of gm
.and factors, international oil and commodity prices, the supply of money, the rate of interest, etc.
all of which determine exports, imports, and demand and supply of foreign currency. At-the back of
these variables lie the supply factors, production function, the state of technology, tastes, distribution
of ~come, economic conditions, the state of expectations, etc. If there is a change in any of these
vanables and there are no appropriate changes in other variables, disequilibrium will be the result
The main cause of disequilibrium in the balance of payments arises from imbalance between
exports and imports of goods and services, that is, deficit or surplus in balance of trade. When for
o~e re~n. or ~nother exports of goods and services of a-country are smaller than their impofU,
disequ1bbnum mthe balance of payments is the likely result. Exports may be small due to the lack of
expo~ble surplus which in turn results from low production or the exports may be small because of
the high costs and prices of exportable good_s and severe competition in the world markets. Important
causes of small. exports are th e m · or nsmg
· fl atmn • m
· • pnces . the country or over-valued exchange rate.
~e_n the pnces of goods are high in the country, its exports are discouraged and imports encouraged.
· by other 1·tems m
If 1t 1s not matched · the baIance of payments, disequilibrium emerges.

~
Balance of Payments on Current Account
·
Balance of payments 18 . .
_ ~ 1 . more comprehensive m scope than balance of trade. It includes not
L --I 1\.__,"'- ~~nkin
: " Y imports and exports of go 0 ds
. .. .
h. h ·· ·
w ic are v1s1ble items but also such invisible items as shipping,
~ ~ J L I l.,.. ~ -' --~ ~ance, tounsm, mterest on investments, gifts, etc.
 Balance of P
. . ayments 719
U'Y say India, has to make PaYin
A°"!1e
,,111,JP'
but ..·· [Link] bankin
also
~-+J.w,.r th
. · g, insuranc ents to ~e ?ther countries not only for its imports of
l. e and ship·p . .
bbl)>'. aY fUl i.u~ e roya ~es for foreign fi mg ~erv1ces ren~ered by other coun~es;
~!JP to pforeign mv~ents m India, or on lo~s, e~penditure ~f Indians in foreign countnes,
!'~~n011al 0rganizanons as the 1.M.F., I.B.R.D.s ;btatned by India~~ other countrie~ and such
jll_.rllitt dlvolve payments abroad. In the . ' tc. These are debit items for India, smce these
jll""~ ·0ns ..... same way £ · . .
• ~11s,ctt f!ndian films and so on, for all of which . ' oreign countries import goods from [Link]~,
~e o5e di . as the latter receives paym t Bth ey make payments to India. These are the cre:<11t
O

~ s for In :ch transactions includin n:n s. alance of payments thus gives a comprehensive
~ of all s . g ports and exports of goods and services.
~uire 1 34 l (given below) we give the · •
r· fab e · position of India's balance of payments on current
2005 2012 - 13 -In this table of balance of payments are given the visible
JJ1 t for the ye~ -06 to
~~ as invisible items of trade. The visible items are export-import trade and the i11Visible items of
p~ e ofpaym~nts on curr~nt account ar~ travel, transportation and insurance, interest on ~
~and other investme~t l~ome_ and private transfers such as remittances from Indians lmng
~d. aoth visible and_ InVIstbl~ items together make up the cu"ent account. Inter~ on lo~,
~ expenditure, b~g_and ms~ance charges, etc., are similar to visible tr~e smce receipts
~ Uing such semces to the foreigners are very similar in their effects to receipts from sales of
ftoOl ~they provide income to the people who produce the goods or services.
~' Table 34.1. India's Balance of Payments on Current Account
.(in Billion US S)

·201'.0?11 lOll-ll ltll-13

256.2 309.8 305.6-
/

I. ExJ>O 499.5 502.2

157.1 190.7 257.6 307.6 300.6 383.5
2. IIDpOrts -189.9 -195.7
--61.8 -91.5 -118.6 -118.4 -127.3
3. [Link] -52.0
(-8.6) (-7.8) (-10.1) (-10.0)
(--6.2) (--6.5) (-7.4) (-9.8)
89.9 79.9 79.3 111.6
42.0 52.2 75.7
4. Iavisibles {Net)
49.6 35.7 44.1 64.1
(1) Non-factor 23.2 29.5 38.9
Services , .
-4.0 -8.0 -17.9 · -16.0
(iz) Investment -5.9 -7.2 -5.1
Income
52.3 53.1 63.5
(iii) Private 41.7 44.6
24.5 29.8
Transfers -125.7 -130.7
-83.0 -83.2
-52.6 -69.0
5. Goods and Ser- -28.7 -32.3
vica Balance
-48.1 -78.l --87.8
6. C■rrent Ac- -tS.7 -28.7 -38.4
count Balance -10.0 -9.6
(-4.2) (-4.8)
(Net) (-2.8) (-2.7)
(-2.4)
(-1.2)
"'Ct·• RBI k ices
if GDP at mar et pr . . . th balance of payments
O
Oft : Figures in brackets show per cent th most important item 1D ef goods In the Table
b e that e d exports o ·
It Will be noted from Table 34.1 a eo:hich refers to i~p~rt:l~the seven years. In years 2?11-12
CUrrent account is balance of trad d shows a deficit ~ as over 10 per cent of GDP m bo~
.1 balance of trade does not balance an ed Trade deficit w d huge current account deficit
. ll increas · th t cause
2012-13 trade deficit substantla y .. these two years . a d anced countries and its spi over
. •n
t Years. In fact, it is huge trade defi~t :omic slowdown m a v
~iw~ iflGDP in these two years c
 720 Macroeconomics : Theo
ry an d Po licy
. ces were respo .
effects in Ernergm .
Ma rke t Ec ~n om 1es cou ple d with high crude oil and gold pris a surplus nsible
for sha . ~ acc ount, there wa
e to sur plu s in inv isib les O
n cur ren
rp increase m trade deficit. Du Ind ia's bal anc e of pay me nts on current a . t
account during 200 I -2002 , 2002-03 and 2003-04 . In ary to popular perception, deficit on ;collll.t
fr been a deficit. Contr easily met by n urrent
om 2 0?4-05 onwards there has is wi thi n reasonable limits and can be
bad pro vid ed it n of::-d~bt
acc?unt Is not always nt acc ou nt rep res ents the extent of absorptio
it on cu rre Plla/
~apital ~eceipts. In fact, defic
ar.
[Link] m India during a ye .
re is def ici t on the cur ren t account, it is financed either by
It may be noted that when the Ba nk of India or by capital flows
that come in;Sll}g
es hel d by Re ser ve ~h e
for eig n exc ha nge reserv
inv est me nt (FD I) and po rtfolio investment by Flis, ex
n direct account in al
country in the form of foreig aod and by NR I deposits in foreign exchange
B) fro m abr r our
commercial borrowing (EC cri sis in 20 08 -09 , the te was first slowdown and then dee ease
financ ial
banks. Howe ver, due to global P on current account wbi h
. exports. As a result, there was a large deficit of 2.4 per cent of GDbil n) as a result of globe 1
m
cap ital inf low s as the y we re quite meagre ($ 8.6 lio hdra a
could not be met by def ici t on cur ren t acc ount in 2008-09 we had to wit w
financial crisis . Therefore, to
financ e the . 2 and2012-I 3
eig n ~x cha ng e res erv es. Ag ain in the last two years 2011-1
US $ 20 billion from our for
AD) has been quite high.
the current account deficit (C and for us
ds to we ake n the rupe~ by raising the dem
demand for us
ren t def ici t ten
It may be noted that high cur to weaken the rupee by raising the
nt acc ou nt def ici t ten ded in this
dollars. In 2011-12 , curre wa s 4.2 pe r cen t of GDP. Since capital inflows
dollars. In 201 I- I 2, the curre
nt accou nt de fic it 8 million us
e the cur ren t acc ou nt def icit, RBI had to withdraw 12.
year were not adequate to fm
anc (se.e Table 34.2) . In
n ex ch an ge res erv es to me et the demand for US dollars cent of
dollars from its foreig it has bee n est im ate d to be even higher at 4.8 per (I)
accou nt de fic
the year 2012-13 the current est me nt by FII s have picked up in the latter ha
lf of2012-13
po rtf oli o inv (//)
GDP, capital inflows through len . Th ere fore, to meet the current accou
nt deficit some US
ou gh FD I hav e fal account (iiil
but capital inflows thr
m for eig n exc han ge res erv es held by RBI. Thus current
n fro
dollars will have to be withdraw
ge to· ma cro eco no mi c ma nag ement of the economy. The dep
endence on (al
deficit poses serious challen the current account deficit is unsus
tainable as these capital Ust
s thr ou gh FII s to me et hange rate
volatile capital inflow ns and the reb y ~au ses sharp depreciation in exc Al
uatio n wo rse I
flows go back when global sit Sou
rket prices ..
of rupee and crash in stock ma ia widened, this
, current account deficit of Ind
- Ill
ars , 20 11 -12 an d 20 12 -13 en
Since in the recent ye
rab ilit y to sud de n rev ers al of capital flows, especially wh
ents vulne
increased the balance of paym ile po rtfo lio inv est me nt by Fils. The priority has the
refore
For
debt and vo lat
[Link] flows are comprised of ) thr ou gh im proving trade balance. Effort
s have been
extt
nt de fic it (C AD
been to reduce current accou ex po rt co mmodity basket and export des
tinations. One
and
div ers ify ing the
made to promote exports by bear the full cost
bri ng pri ces up to the int ernational level so that users to
way to limit imports is to en revised upward in Jan. 201~
ed an d die sel pri ces ha ve be
decontroll Us
Accordingly, petrol has been rts of go ld wh ich has played a significant role in
causlDS
urage the im po OfI
curtail sub sidy on it. To disco .
sto ms du ty on its im po rt ha s been raised from 4% to 6% 09
trade deficit, cu ating remittances
cu rre nt acc ou nt de fic it emphasis has been on facilit are
Further, to improve the isible account.~
be en res ponsible for swplus on the inv ace
and encouraging software
recent years this surplus has
ex po rts tha
lowered the
comp on
t

en
ha

ts
ve
im
tog
pa ct
eth
of
er
wi
me
de
t ne
nin
arl
g tra de deficit on current ac co ~t def
y two-thirds of the trade deficit
~:
to;~:.
that r icit
oy
\Va;
(CAD) significantly. The two .2012-13. Remittances p~ cu
lar ly are kn o~ 0 for1
r cent of GD P in 20 I 1-1 2 and bal cnsis
more than 10 pe ter na l sho ck as was evident dunng the glo
try is hit by ex
resistance when the coun
pital Account ·t ms are.
Balance of Payments on Ca in Ta ble 34 .2
·
im po rtant 1 e 5
· on capital account giv en
In the balance of payments g fun ds to other coun trie s. Th is tak es two for nt ·
n countrie s an d len din
_~ \!A ~ ~gs fro ~ foreig
-, .. w,, l ¼I w1
 Balance of
•--'erflal assistance which m Payments 721
·) £~•t' (ii) ..,omm
r • eans borr · fro c- .
(1 erc1a/ borro w· owing
. ieres ' fr mg und m ,ore1gn c sional rate of
Jfl doW funds om world money ma k er Which the Ind · ountries under conces
bD" sits are another import ant item in r et .at I11·gher mark t ian Gove mment and the private sector
t. Th e rate of interes t. Besides non-resident
oed~.,s (NRI) who keep their surpt funcap1tal accoun · ese are the d ·
· l us ds epos1ts made by non-resident
,,111ents on capita accou nt isfi . ; With Indian bank s Ano the .
111 JiJ"
of par . . ore,gn ent by c-o . . r important item in balance
~ s of foreign investment. First 1·s POrt_fi I'nvestm
, ll feign COm • •
\ o,PC •~vest mentu nderw b· pam~s ID India._There are two
\l [!)purc hase shares (equity) and bond o io
investors
.~ . h s oflnd1an companies d G1ch foreign mst1tut1onal
t~ ct investment (FDI) under wh ic an overnm ent Th d. .
\~ ;,re . . foreig n
. companies set u 1 · e ~econ 1s/ oreign
in coI1aborat10n with the Indian
~\ f
,
11 wS in which the important sourc co;pan,es. Still another it~
Pants and factones on their own

~ : rking in foreign countries. Tab!: 34 ° ~;~

is ~emittances from :~::~ ~~c :~! ;:te r ~pita!
,~
· est e position of India's capita tanthe
. 1 account for CJ izens
years
..,()()4-05 to 2011-12.
~ Table 34.2. India's BaIance of p
\ ayments on Capital Account
(in Billion US S)
2005~06· 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12
External Assistance (Net) 1.7 1.8 2.1 2.6 2.9 4.94 2.3
c0nunercial Borrowing (Net) 2.5 16.1 22.6 7.0 2.8 12.16 10.3
Non-Resident Deposits (Net) 2.8 4.3 0.2 -4.3 2.9 3.14 11.9
A
' foreign Investment (Net) of 15.5 14.8 43.3 3.5 50.4 42.13 39.2
I
which
~ 22.1
(i) FDI net 3.0 7.7 15.9 17.5 18.0 11.83
(ii) Portfolio Investment (Net) 12.5 7.1 27.4 -15.0 32.4 30.3 17.2
2.4 9.2 39.7 -9.7 -13.1 -10.48 -7.0
(ii1) Other capital flows (Net)
24.9 46.1 107.9 8.6 51.6 63.74 67.8
Capital Account Total (Net)
- 15.0 -36.6 -92.2 +20.1 * -13.4* (-13.1)* (+12.8)*
Use of Exchange Reserves*
• Also includes errors and omissions
s (-indicates increase of reserves and
:~und~e: RBI Annual Report 2012-13. Use of foreign exchange reserve '
m 1cates decrease of reserves on BOP basis.
g and non-debt creating.
F ~ap_ital inflows in the c_apital account c~n be classified into debt creatin
g capital inflows whereas
oreign mvestment (both direct and portfolio) represents non-debt creatin
external assistance (i.e. concessional loans taken from abroad), extern
al commercial borro ~g (ECB)
andnon-resident deposits are debt-creating capital inflows.
l inflow of 43.3 billion
It will be seen from Table 34.2 that during 2007-08, there was net capita
USdollars on account of 1oreign [Link] (both direct and portfolio).
Table 34.2 gives the position
Jlents in capital account for seven years, 2005-06, 2006-07,
2007-08, 2008-
oflnd'1a,s balance of paym
nts on capital account
09 and 2009-1 0, 20 I 0-11 and 2011-12. When all items of balance of payme
8. Talcing into current
are taken into account we had a surplus of 107.9 billion US dollars in 2007-0
exchange reserves
account deficit of$ 15. 7 bil1 ion in year 2007-08 there was accretion to our foreign
l account balance as there
by $ 92.2 billion in 2007-08. Global financial crisis affected our capita
$ 20.1 billion of our
;as. reversal of capital flows after SepL 2008 with the result that "": used
.• 8-09 resulting in decrease of our foreign excha nge reserves. That
.ore1gn exchan . our
ts ' because w ge reserv
d '"' m.
es 200 $ 0 1 b'll' th
change reserves equal to. 2 .. •1 ton, dere was dec1·me m
n ex · 2009 10 &-. •
. exch e use our 1ore1g
foreign b $ b'lli'on in 2008-09. The s1tuat1on improve 1m - as 1ore1gn
. · l
d'lrect inv tm ange reserves y 20 fi .1 ·nvestment by Flis picked up. As a resu t there was net capita
.
. g the current account deficit of$ 38
account es ent (FDI) and .port . o.1to 1 9 1o and after meetm
8urp1us of$ 51.6 bilhon m
200 -
 , ££
c ,' ' . . Theory and Polic y
1 J Macroeconomic5 ·
1
bf~, th . h ge reserves by$ 13 .4 billion in 2009
B.J~2 t~ ere was addition to our foreign exc :; billio
i1 ) er~ ~as surplus on capital account of$ ·. 74
n and after meeting curre ' 10 -Itt io
r 1
-1
>
hllhon in our foreign exchange reserves m2010
.11.
. .
ntdeficit\Ve lo,
11
aqd~~
However, in 2011-2012 and 2012-13 the s1~aft oncurre regardmg capital flows ch
•
i , 'II
nt accou
~ '~ d capital flows were not sufficient to meet the arge f 12 8 billio nt deficit (C~g ed si&[Link]
;m 2011-12 withdrawal from foreign exchange reserve~ odr n US doll ). Conseqicantly
~ ~rs Was lllade Lllently
I ,
. I fr
1 113 also due to
large deficit on current accoun t the with awa om our 1oreign ex h · ti12 0 ,
was made. c ange re 12_
8
et'ves
Ca ital flows are driven by pull factors such as econ?mic fund
p a~en tals of recipient
•
and push factors such as pohc y stance Of so urce coun.
tnes. The capital flows h
. .. ave
. counttj
Itnpl'
for exchange rate management, overa11 macrOec onom tc and financial stab1hty incl d' 1cat1!11,. . es
conditions. Capital account management therefore needs to . · u tng Ii u·v,~
~mpha~ize pr~moting foreign\ ~dity
investment (FDI) and reducing dependence on volatile p~rtf
the extent current account deficit is bridged through capital
oho cap~tal. This would ensUre
surplus it would be better if it • to
th:~
through stable and growth enhancing foreig · n direc
· t mves
· tment fl ows. In the present mtern · is .done
financial situation reserves are the first line of defence again
, . st the volatile capital flows H ationa1
the decline in reserves as a percentage of GDP 1s . owever
a source of concern. '
Large Invisible Surpluses. At a micro-level the balance of paym
ents profile reveals important
trends. In the recent years deficits in the trade account have
been made up by the large invisible
surpluses resulting in a small deficit in current account balan
ce. The robust growth in invisibles i:r
due to large inflows ofprivate transfers and non-factor services.
Buoyant inflows of private transfers
have been one of the main factors contributing to rem~kable
growth in invisibles. The current high
level of private transfers which comprise largely inflows of remit
tances from Indians working abroad
have made India the highest global recipient of remittances.
The bulk of these remittances come in
from expatriates in the USA and the Middle East.
In addition to private transfers, the contribution of non-factor
services to the invisible account
has been increasing steadily since 2001-02. This contribution
increased further in 2006-07, 2007-08,
2008-09, 2009-10 and 2010-11. Among the non-factor servi
ces enhancing the invisible surplus is
the buoyant earnings from software services. Net inflows from
software services increased from US
S 6.9 billion in 2001-02 to US$ 10 billion in 2003-04. The softw
are services (net) recorded arise of
31.7 per cent during 2005-06, 30.4 per cent in 2006-07 and 28.3
per cent in 2007-08.
The high skill intensity of the Indian workforce has given a
decisive comparative advantage to
Indian software services exports and has helped the country in
carving out a niche in the global market
for software services and IT-enabled services. Besides, in recen
t years, India has emerged as one of
most preferred destinations of outsourcing IT services from
advanced economies. While softWare
services exports more than trebled between 1998-99 and 2003
-04, exports ofIT-enabled and business
process outsourcing (BPO) services have increased significan
tly in recent years.
On _the other hand, the capital account surplus has not been
growing strongly due to unstea~
growth 10 non-de~t creating[oreign investment flows. Though
debt-creating capital inflows thrO~gio
external commercial borrowmg and external assistance have
been significantly brought down~
fact in many years there were net capital outflows on these coun
ts. However it is a matter of serto~
concern that m · recent
years our dependence on volatile capital inflows throu'gh portfo · · estJJlen
by Fils has largely increased. · ho 1JlV

. It is evident from above that trends indicate that the fast grow
ing invisibles and non-debt creati";,
fiorezg· n inves
· tmentflows are
the mam · facto
rs behm· d
large accumulation of foreign exchangereserve
 . Balance of Pa
11,ianc
e of Payments must aIWays b J Yments 723
MtS17 .
Y" It is often said that balance ofp
a ance ?
firm f aYin ents m .
buSiness . s o an economy have to ust always balance
pay for the import fr · Wha t does it mean ? The individuals
,i1d yfor the unports, then how the ba1ance s om abroad · exports are not sufficient
If
pSyrnents on current account of Indi h of PaYinents will b .
it~ em balance. For example, the balance
fpSurrent account implies that the a_ ad been in defic cit
11 c o'l/ices than the incomes the .resid
ents of a country or most of the years till·2000-01 . Defi
Y are earn· are spen ding m
dse1 • exports of ore ~n imports of goods
ce of payments to be in balance . tng from good s and services. For the overall
an b financed by selling c . l 'this deficit in the currae:t;cco unt of the ba~ance of payments
ust y old or foreign exchan ap1ta assets such as shares
ge reserves of a coun n onds of compames or other assets
cbas g .
by ~orrowing from abroad. Both by selling
ets or by borrowmg ~om abroad, foreign ca i try or
the last several years m India. These :f;oreig . p tal flows mto the country as has been ha [Link]
f payments Wh1c · h must be in surpnl capital infl ows are shown in the capital account of
et,a1an ce O
current account. Thus ,
current account d .~ . us to finance the deficit in the
e1 ,cu + capital a t
it is wort hwh ile to note th t th' ccou n surp1us = 0.
However, a 1sto"bala · · h_e accounting sense only. Surplus on
nce" ts
n~ can Iead to the gran t oflo ans th mt
nt accou tries by the Government or it can lead
e ot?er coun
the increase m the reserves of foreign e •. h
show up 1?em_selves in the capital account.
the other hand, a deficit on curr~nt ate ange which
by capital mflows from abroad, that is,
obtaining foreign investment or gettingc~un~ can _be met
by ~a~ g from IMF or by running down
untry's foreign exchange reserves. Thus ti:ei gn aid or
ance of payments gives rise to further fm S?1J>lus
or d~fictt m ~e current account of a country's
ancial ~ansac~ons W~tch show up them selves in capital
unt. In other words, if the balance of paym ents ts used m the wider sense so as to include external
. dra • fr IMF dr . as distinguish ed from its
, awing upon the country's reserves also
istance, wmg . om the receipts taken
always balance-all
ower sense, the balance of payments of a country must
ether must be equal to all the payments taken together.
borne in mind. If a country has no foreign
The above fact h~ an important lesson that must be
imports and if nobody is willing to lend
. e~cy ~eserves or 1t has no. as~ets to sell to pay for the
ce productive activity in the economy and
1~ 1t will have to cut down its linports which will redu
crisis situation arose in India in 1991 when
ersely affect economic growth of the country. Such a

t foreign exchange reserves had fallen to a very low level

eus aid. In fact, due to loss of confidence of foreign inves
Therefore1' in 1991 India had to mortgage
~an to get the necessary foreign exchange to pay f~r the
.
and no one was willing to lend to us or
tors, capital outflows were taking place.
its gold to Bank of . •
England and Central Bank of
needed tmports. We had to accept the
over the crisis. It is interesting to note this
Jltconditions of IMF for providing us assistance to tide
Wis done under the guidance of Dr. Manmohan Sing
h, the former Prime Minister of India, who was
·
ten the Finance Minister.
ANCE OF PAYMENTS
GLOBALISATION CAPITAL FLOWS AND BAL
The globalization of ~e Indian economy has an price importan~ co~sequence with _regard to capital
s of its lDlports and a given demand for
lows m·to th economy. Suppose Ind'1a faces given • domestic ·
· rate of 10ter est (or rate
. ex e . U d these circumstances, 1f
s abroad, then, given the mobility of
r ports o! goods and ~en:ices. nc;~ ared to what exist

i to a very large extent. This principle can ,

:ml on_ m~e s~en t) _is high~r as h tdia n economy
, foreign capital wdl flow 111to t e . .) ,_)
. l~
expressed as~10IIows. BP == NX(Ytl 1t, R) + CF (11- Id
~.'
'let . 1 rts (t e exports-imports which is also called trade :
15 0 expount of the balance of payments, that is, capital flo~n
lilaneBP : balance of payments, NXcapit. a~ ac~~ represents rate of interest in the domestic econor ,_;
- ce), CF stands for surplus in_ the
t...._ o ~
l"'J lTesents rate of interest in foreign market an d • (l

- .J
 124 Macroeconomics : Theory and Policy
of level of d_o~estic incorne
The above equation reveals that trade balance (NX) is a function_ th
An in~rease m e domeShc income due to
( Yd) and foreign income (1!) and real rate of exchange (R).
~dversely affe~t the tr~de balance
higher industrial growth or fall in real exchange rate of rupee will
(NX) by increasing imports. i_r- id in the above equ_ ation meas~res interest rate differential between
l flows depend · Furt~er, the above
the foreign country and domestic economy on which ne~ capi~a
as_ compar~d to th at m_the foreign
equation shows that higher interest rate or rate of return m _India
s mto 1ndia. Such capital inflow
country such as the United States will cause large capital inflow
l inflow s into the Indian econorn;
have actually taken place in India since 2003. Due to large c~pita
J?ecember 2oo 3'.reached 170 billion
our foreign exchange reserves crossed 100 billions US dollars ~
n US dollars m September 2007
US dollars in December 2006 and further increased to 247 btlho
capital flows , there was decline i~
and to 300 billion US dollars in Sept. 2008 , Due to reversal of
, they st00 d _at ~S $252_ billion. In
our foreign exchange reserves in 2008-09 and in March 2009
and capital mflows mto Indian
the second half of 2009-10 there had been reversal of capital flows
ing in i~cr~ase of fore!gn exchange
economy occurred on a large scale in 2009-10 and 2010-11 result
dechne m our foreign exchange
reserves to $ 304 billion at end-March 2011. However, there was
294 billion in end-March 2013.
reserves in 2011-12 and our foreign exchange reserves stood at$
gh globalisation and openness
Globalisation has both advantages and disadvantages. It is throu
promotes economic growth. Trade
of an economy that foreign trade of a country increases which
of goods and services according to
between countries help them to specialise in the production
globalisation helps in the transfer of
their factor endowments and comparative efficiency. Besides,
ries. Globalisation also promotes
technology from the developed countries to the developing count
Capital inflow in the form of foreign
capital flows between countries which in general are welcome.
ry by increasing capital accumulation.
direct investment (FDI) adds to the productive capacity of a count
ign Institutional Investors), which
Capital inflows in the form of portfolio investment by FIis (Fore
nt bonds, lead to the development
are invested in buying equity shares and corporate and Governme
nge which can be used to meet the
of financial markets. Besides, capital flows provide foreign excha
country such as India due to large
current account deficit which generally emerges in a developing
for industrial growth of the economy.
imports of fuel, machines and industrial raw materials required
ated in the sub-prime housing
However, the global financial crisis of 2007-09 which origin
y brought out the adverse impact of
loan market in the [Link] enveloped the entire world has clearl
oping countries such as India which
globalisation. It adversely affected growth of exports of devel
l outflows from them which led to
brought about large current account deficit. It also caused capita
they hurt macroeconomic stability.
the stock market crash. When capital flows are large and volatile
to appreciation of exchange rate of
Large capital inflows as they occurred in India in 2010 lead
affects growth of our exports and
the national currency (Rupee in case of India) which adversely
it.
encourages imports. As a result they widen current account. defic
es about the extent of openness
Owing to these adverse effects of globalisation each country decid
some restrictions on their foreign
of its economy with which it is quite comfortable by imposing
se effects oflarge capital inflows,
trade, especially in financial services. Besides, because of the adver
on capital inflows. However, in case
some countries are trying to control them by imposing taxes
absorptive capacity. In 2011-12 and
of India size of capital inflows till 2010-11 were within our
nt ~ccount deficit (CAD). Therefore,
2012-13 there were not sufficient capital inflows to meet our curre
s on them.
we need larger capital inflows rather than putting any restriction
nt account deficit of India was
Although in 2008-09 due to inadequate capital inflows curre
2009-1 0 and 2010-11 it was financed
financed by withdrawing from foreign exchange reserves but in
ption of foreign capital inflows. If India
- 1 ?~-sJ;11>Ius in capital account and thus there was gainful absor
current account of BOP since growth in
- '~ ~ to grow at a high rate of 9% there will be deficit on industrial
1
..: ·JU! F•I~:£it:.. 'J!n:~ot keep face
1 with our higher growth in imports due to rapid increase in our
 Ba lan ce of P ~ . . . ,_ __.

.,rf"ent account deficit is a rnatter f ncern

ayments 72!. .., -~ - --
.
. ·r;. Ce not adequate to finance th e curreontco
uvl
i.µ•
ac only if growth 18 .
t
.
hig h or if stable capital
t de fic it no
, ws sr be seen from Tables 34 1 coun
il ·JJ ce ed ed · and 34 .2 that tirorn 20 ·
o
It W![Link] acco un t (n
· I
et)] ex our curr ~nt account deficit05e- 6 to 2011 - 12 capital surplus
ciP .,..
1
t there Was add; years 2008-09 and
[il' /1 with the resu t_tha to ou r foreign ~x;cept for the
(- ) sig n in the ho n
. hange reserves (se
e last row of
;OJI-34.2)- Note that mmus es in th use of res erv es c vano us . . of
p~le r. reilTfl exchanthge reserv . ese [Link] s We added toaor fi . years implies that instead
,;It£ iO Ei~ was glo ba l fi exchange res erv es . In the
yv , ()()8·09 when ere s ;an c1 al crisis which ca:ur dore1gn
tflow in our
th e Indian econorn;e ~~t only negative gro·...vth
f 2 but also lar ge ca pital ou
d fel l sh ort orn
~~ .0 9 was quite small an cu rre nt acc
pital ~ rpl~
ount d; .~ itt :~ ;;~ ~ that ~a large m this
$2 0 bi ll io :~ : as qurte
~Z~ 5 3 resul~ we withdrew nce the I m our foreign exchang current
f· t deficit m 20 08 -0 9. He
for e US $ 20 in 2~ :~ :e Hs to meet ~he o
l oflarge capital in fl o:s us
_shign h_e • owev 1· 09W-1
er, m 20
~was reviva d ti · ·
Wt t capital
t ad ofwith _acdrcount. (net) equa l to US $ 51 6 b·1
. 1 mn . erv1es
ith
t,tfC
4 billio n e cit m cu rre nt account we m· se m ou r for eig n exch ange res
1g
S-' · · 2009 . This means Indi awmg fro and its
. added to them m -10
aga m· a ~u cc~ ssf ull y tac kled global financial crisis
,re sequences. However,d fi .
in 2011-12 capital mflow s m . Ind'ta were not sufficient to meet
t and as a re It [Link] $ 12 .8 bil· lio · from our foreign
cDn
t,11y our current acH count e 1c1 . 2012-13 - capitsual we had to , n
ev er m . fl n direct investment
change reserves.
1111 ow ~w s ~t o Ind ia through for eig
account de ficit him h en financed
: declined and our current wh ich ~ c ts eS ti~ ate~ to be quite high has be
JllOre by volatile capital
flows by Fl is
of se no us concern. This is because [Link]
hi s a ma tte
r foreign c ange rate stability stock r k · · · bil ,
Jarile capital flows affect ou ex , mar et pnces, pnce sta 1ty
vo ic instability.
and thus create macroeconom
E OF
IUM AND DISEQ UILIBRIUM IN THE BALANC
EQUILIBR
PAYMENTS
like to
dis eq uil ibr ium in the ba lance of payments we would
Before we analyse the caus
es of ove that when
ium in the ba lan ce of payments. We have noted ab two
explain what is meant by .eq
uilibr
rre nc y an d all the so urc es from which it comes, these
r foreign cu necessarily
we add up all the demand fo thu s the ov era ll ac co un t of the balance of payments
l and
amounts are necessarily equa
balance or must always be
in equilibrium. is 'in
we say tha t the ba lan ce of payments of a country
when uilibrium
What then do we mean by r of fac t, wh en we sp eak of equilibrium or diseq
tte
equilibrium or disequilibriu
m'. As a ma
ce on tho se pa rts of the ac count which do not include
refer to the balan Rs, drawings from the reserv
es
in the balance of payments we fro m the IM F, us e ofSD
ch as borrowing cluding these accommodati
ng items
the accommodating items su ntr al Ba nk , etc . Wh en ex
of foreign currencies
held by the Ce payments, it is said to b~ in
e?uilibn·un_,.
in the ov er all ba lan ce of
there is neither deficit nor su
rplu s
su rp lus , the ba lan ce of p~yments is said to be m
either deficit or by ~awmg~ from the IMF, For
use of
~ n in this sense, there is ym en ts ca n be fm an ced
balance of pa eived from ab_road.. .
disequilibrium. The deficit in of~ ore i·g n cu rrencies and loan and atd rec ,
DRs ' drawm·gs tirom the reserves ouu r foreign exchange reserves to the tune of 11,75 7 million
d to ent on current accountort was
pie in 200I-0 2 we adde. I ea rs In dia 's ba lan ce of paym res ed
Sdollar ' y fr IM F fro m other countries or even
us severa was
lb deti . s. However for previo iad·aborr~ 7e ! ,;:alanceo:f payments for the year 200 1-02
fo co:·
&
T~ finance t~e deficits Ind . 8 u 0 1
erc1al borrowmg from ab
ro
Items . . .
vourabie. Item• and Accommodatin& whbnum has been
•••le B•lanee of Payments' Autonomou cept of balance of paymenautstoneqom
I
ous items in the
ij ar co~ ba sed upon the idea of
nt and ~p ul are those items which cann
ot
of h ?Wever, a more importa t~ c~ : balance of payments
ba
t of bas•~
baia:31c balance. The coencau~p
tonomous items in
ce ofpayments. Th
 726 Macroeconomics : Theory and Polley
•
· or qmcldy
be influenced or changed so ·easily by the Government an d they are determined b
1
ong-tenn factors. In this concept of basic balance, besides the items in the current account /10,
~~rm capital movements both on private or Government account con~ined in the capi~I~ e ng.
ance of payments are regarded as autonomous. On the other hand, m the capital accou aceollllt
term capital move~ents s~ch as borrowing from 1MF or ~entral Banks of ~ther countries, ::,: 11.
0

from SDR, change m foreign exchange reserves are transitory and of accommodating nature ing.
therefore excluded from the concept of basic balance in the balance of payments or of equ1-1~1 arc
of payments. The recourse has to be made to these accommodating items (also called comp Urn
items) so as to ensure equality between payments and receipts of foreign exchange. Change;'3,atory
compensatory items are made so as to offset the surplus or deficit in the autonomous itern/ in the
when autonomous movements cancel out over some appropriate time period and there is M ne-:;ua'
compensatory movements, the balance ofpayments is in equilibrium. Note that the equilibriu,n 13(or
a
state ofbalance which can be sustained without intervention by the Government.
The concept of balance of payments in the sense of basic balance can be represented by the
following equation: ·

(X-M)+ LTC = 0
where X stands for exports including invisible items.
M stands for imports including invisible items.
LTC stands for long-term capital movements.
If (X -M) is positive (i.e., X> M), then for balance of payments to be in equilibrium, [Link]
be negative and equal to (X - M). This implies that there will be net capitafoutflow. On the other
hand, if M > X, then for the balance of payments to be in equilibrium LTC must be positive (that is,
there will be net capital inflow to offset the deficit in the current account).
When the balance ofpayments ofa country is in equilibrium, the demand for the domestic currency
is equal to its supply. The demand and supply situation is thus neither favourable nor [Link]
the balance ofpayments moves against a country, adjustments must be made by encouraging exports
of goods, services or other forms of exports, or by discouraging imports of all kinds. No country
can
have a permanently unfavourable balance of payments. Total liabilities and total assets of nations,
as of individuals, must balance in the long run.
·This does not mean that the balance ofpayments ofa country should be in equilibrium individually
with every other country with which she has trade relations. This is not necessary, nor is it the case
in the real world. Trade relations are multilateral. India, for instance, may have balance of payments
deficit with the United States and surplus with the United Kingdom and/or other countries, but each
country, in the long run, cannot receive more value than she has exported to other countries taken
together.
Equilibrium in the balance of payments: therefore, is a sign of the soundness of a country's
economy. But disequilibrium may arise either for short or for long periods. A continued disequilibriwn
indicates that the country is heading towards economic and financial bankruptcy. Every country,
therefore, must try to maintain balance of payments in equilibrium. To know how this can be done
involves the study of the causes of disequilibrium.

CAUSES OF DISEQUILIBRIUM IN THE BALANCE OF PAYMENTS

paytne: •
There are several variables which join together to constitute equilibrium in the balance of
· position of a country, viz., national income at home and abroad, the prices of goods and factors,
supply of money the rate of interest, etc., all of which determine the expprts, imports and detn~ •
and supply ~f f;reign currency. At the back of these variables lie the supply factors, pro<fuctl~ •
 Balance of Payments 727
tes th d' tri'b . . e th tat f . . . s, etc . If
the state. of technology' tas ' s e dtsth utton of incom , te s h e o an.ttc1pat1on
·oos, of these variable an ere are no appro pr · e c ange s [Link] variables,
,,11ctl. change .mbany . ia
,.,.. 1s a ll e the res ult .
~etc ·Jib riU IJl wt
. .
·seqlll .
of the dis eq uil ibr ium in the b Iance of paym ents an ses from imbalance
~ be main ca d imports of goods dus e . a
n for 0 ne reason or another exports of
f exports an an serhvices . .Whe .
. sm II Tb · · h of
H11eeJ1
i,e1" d services of a country are a er t an thetr imports, disequi I num m t e balance in
·..nds an . Exports m b portable surpl us wh ich
F'~. is the likely resulttio or the ay e small due to the lack of ex
paro1en~t from low pr od uc n
cau~e of the high costs sm and prices of
i:: ~: : ma y be sm all be of all exports
co m pe tit rkets. An llllportant cause
!IJ!ll res:Ie goods and severe . the country Wh h . e wo rld ma
#rtawflatton . or ns. m . [Link] m e pnces of goods are high ms in the bala~ce
in the country its
g · en t
d d. by other ite
~ tbe di
l~b _an un po rts en co ur aged . If it is not matched
t$P°rtS are dis~oura~ 1 num emerges ;
fpayJllents, seqm
0
cJjcal Disequilibrium
er us ed by th fl · ns m · the econotn1•c activity or what are known
ium is ca uc tua tio
eyclical disequil . ibrth . e
pri ce s of goods fall and incomes of
the people go
0 nods of pr os pe rit y, goods
1
~ trade eye e~ ~ g . e pe le an d pri ce s of go od s aff ect exports and imports of ·
(k)Wll• These_ c anges Ill
mcomes of the peop · ·em · prospenty · and declm · em· depress10n,
ce of pa ym en t s. "I f pn ce s ns
-~ii [Link]
auu . e the ba . lan
.
ity will experience a tendency
for a decline
po rts gr ea ter tha n un e
8coun1rY wt
th ~ pnce el~tictty for im
se for wh ich im po rts pr ice elasticity is less than on
in the val~e of unports 1D
prosp~rity, while tho y be overshadowed by the eff
ects of
Th ese ten de nc ies ma
mcrease. nd will bring
will expenence a tendency for ely , as pri ce s de cli ne in depression, the elastic dema
Convers
jncome c~anges, _£ c~urse.
0 1
, the ine las tic de ma nd a decrease. "
about an mcrease m nnports
ilibrium
Secular or Long-Run Disequ ents occurs because of lon
g-run and
in ba lan ce of pa ym
Secular (long-run) disequil
ibr ium
s fro m on e sta ge of gro wth to another. The current
onomy as it develop one stage to another. In the
initial
deep-seated changes in an ec s a va ryi ng pa tte rn fro m
yments follow ceed exports.
account in the balance of pa tm en t ex ce ed s do me stic savings and imports ex
estic inv es the
stages of development, dom fun ds av ail ab le to fin an ce the import surplus, or
lack of sufficient wth when
Disequilibrium arises due to le ca pit al fro m ab roa d. Then comes a stage of gro
by availab sequilibrium
import surplus is not covered sti c inv est me nt an d export outrun imports. Di
ceed do me savings or because surplus
domestic savings tend to ex fal ls sh ort of the su rpl us
term capital outflow still later stage of growth do
mestic
may result because the long- op po rtu nit ies ab roa d. At a
investment balance, zero.
savings exceed the amount of tm en t an d lon g- ten n capital movements are , on
stic inv es
savings tend to equal dome wh en eit he r the long-tenn capital moveme
nts
equilibrium wi ll oc cu r ings
Thus we see that a secular dis tor s aff ec tin g sav ing s an d investment, or planned sav
get out of adjustment with
deep-seated fac movement of long-tenn
capital. If
of fse ttin g ch an ge in the
and investment change wi
thout an
of do me sti c sav ing s plu s foreign capital there could
dily to the amou nt
investment adjusted itself rea
equilibrium. flow falls into
be no tendency for secular dis in eq uil ibr ium , if the ~tem~tional capit~
posit ion wi ll be ncy to
. The balance of payments est me nt mi nu s do m~ st~ c savmgs. The~ 1s a tende
of domestic inv st1c investment are mdepen
dent of the
line with the requirements me sti c sav ing s an d do ~e ped
use of do g t':11denc~ for ~derdevelo
&ecular disequilibrium, beca gn itu de s. Th ere 1 s a str on
of different ma ed countnes are mvesting econom1c
larger th ~
foreign capital flow and are r-s av e. Th e un de rde ve lop
r unde
countries [Link]-invest and/o rts allow them because they are. ea ger to·acthclerat e the rate of
d . · b 1 ce of payments.
their domesti. c savmg • an expo
s t causes a secular disequtl
1bnwn m e a an
d ·
. . L·.1'T'L
"'"o•-,.-1 \ WS ten ency
: to over-mves
r -\_ -_ , - - -c_r, op. cit., p. 526.
0
• \_

~
ti 1. C.I~Kruil~b~g
 . -rh
11 e
ory and Pol icy
Macroeconomics :
728
m · caused by various techn o1Ogic I
Technologi cal Dis equ ilib riu of payments iss of new goods or new techni a
. . . . . th ba1anee . innovation
Technological d1se qu1 lzbr zum m e d · ques
· l changes mv · olv e inv enti onsh
or
dem and for goods and pro uct1ve factors wh·
changes. Technolog1ca nological change iznpi·ieslcha
ofproduction. These tech· nologi cal changes affect t fe ayments · Each tech . .
. . ·t in the balance od'uPsts. The innovat10n leads to mcreasedexPo
m tum influence the various 1 ems _ •~
~try ~ie inn ovation may lead to decline in imports
increa:.. ~
adv anta ge to ~hic J~ a cou
new comparative
goo d and e~p oit- brns ed !nn o~~ -~o~ . A new equilibrium will require either ~
if it is a new crea te a dise qUJ 1 num.
is imp ort- bias ed. Thi s will
imports or reduced exports.
. . " . . .. .
Structural Dis equ ilib riu m uct ura l d1se qu1ltbriu,n t
f disequilibrium 1s caused . Str
1 alters a previously existinag
Let us see how the structur ha typ~ od mand or supply of exports d h· h · · .
occ urs whe n a c ang e m e un er w 1c mco me 1s earn ed or
the goods level ' • th basic circumstances h · th 2
· m e
equilibrium or when a change'thoccturs the req uisi te par alle l cha nge s elsew ere m e economy.,,
' . b th
spent abroad, m o cases w1 ou engaged in the
· .c. • tn·e s for Indian handicrafts falls. The resources . .
Suppose demand m 1ore1gn coun som e oth~ r. l~e
t
or the coun1?' muS reStTict imports ,
dicr afts mu st shif t to
production of these han qmhbnum. A change m supp!y may a~so
.cause
ntry wil l exp erie nce a stru ctur al dise
otherwise the cou shift m the
dise qui libr ium . Sup pos e Ind ian jute crop falls because of the change m the
a structur al art from goo'!5, a loss
-pattern , Ind ian jute exp orts will fall and a disequilibrium will be created. Ap
crop ount. Besides , the
nce of payments position o~ curre~t acc
of service income may also upset the bala has proved a fatlure or 1t has been confiscated
aris e bec aus e fore ign inv estm ent
loss of income may structural
e.g. nati ona lisa tion of An glo -Ira nian Company in Iran. A war also produces
or nationalise d,
ds but also factors of production.
changes which may affect not onl y goo tion or decreased
nge can be filled by increased produc
A deficit arising from a structural cha increased exports or decreased imports.
affe ct inte rna tion al tran sac tion s in
expenditure, which in tum tively immobile and expenditure not read
ily
so eas y bec aus e the reso urc es are rela
Actually, it is not t a serious
Un der suc h circ um stan ces , mo re drastic steps are called for to correc
compressible.
disequilibrium. fail to reflect
level results from factor prices which
"Structural disequilibrium at the factor out or line with factor endowments,
me nts ... i.e., whe n fact or pric es, are
accurately factor endow resources which appropriate factor pric
es
of pro duc tion from the allo cati on of
distort the structure sparingly
icat ed" If, for inst anc e, the pric e ofl abour is too high, it will be used more
would have ind This will lead to
cou ntry will imp ort hig hly cap ital -intensive equipment and machinerry.
and the labour on the other.
qui libriwn in the bala nce of pay me nts on the one hand and unemployment of
dise
Conclusion
ve fou r type s of dis equ ilib ria- cyc lica l, secular and two kinds ofstructural
We have explained abo ges
how they are cau sed . In eac h case , the causes manifest themselves through chan
disequilibria- 1md ·
one exceed the other.
in export of goods and services, making
Any cause that
hav e alre ady deta iled the var iou s item s that enter into the balance ofpayments.
We
-sid ed mo vem ent in tho se item s may cause a disequilibrium. For instance,
leads_to a persistently one merchandise, imports remaining unaffec
ted
lead to fall ing off in the exp ort of
certam _cau~es may causes. Take,
the opp osit e dire ctio n. Fal ling off in exports may be due to all sorts of
or movmg m e of decreased
e, the cas e of exp orts and imp orts of goods. Our exports may fall becaus
for exa ~pl rnational
to sea son al fact ors or oth er cau ses. The demand for our goods in the inte
production due or because
fall off bec aus e of a fall in the pur cha sing power of consumers of such goods ·
, m:iark~t ~Y
cos t of pro duc tion in Ind ia whi ch reduces our competitive strength in the
-__,M!. i~p ara tiv ely high
l
2'• G.'. ~l Kit:J!xerger, op, cit,, p, 526.
 ts
Balance of Paymen 729
/ .
tional marke t. Our exports may become dear to fo re igners bec au se of an appreciation of our
. . .
. tef1la
iP batlg
et:iar . If
e ra
we
te ,
pe
th t . ns
rs
a
is t
ts,
in
a
ar
e
tif
m the value of th
icially keeping th :
d d
:r::,os;~
fro
he
m
ru pe
f
e
42
at
.50 ~er US dollar to f
a hi gher
•
40 per US
level than justified by
dO omic forces, unfa
vourable balanc e of tr a e an paym ents w1'II t end to persist.
· d .
coll
sam e w ay , di se qu ilibrium may ar ise ue to ex ce ss 1v · or serv ices neith er balance
d
e In the ex . e im po rts
mni ties
· pita], etc. Compulso rm of reparations or indeeen the
exports nor tmp?rt of case bry ports m th e fo
bY cause internat10n
a1 di quilibrium and o struct the harmon ious trade reJations betw
~so tries concerned. 3
cotJll
UILIBR IU M C AN BE CORRECTED
. ~0":7 ~ISEQ ,
t~, steps must be taken
a co to
rium arises in
When senous diseqmhb omy is to be ke ~ tr y s balance :¥aymen usly, the causes whi ch
0
on . Obv10
rrect it, if the country 's ec sta te of ffi •
nd
pt tn a sou condttton sic al ' view of the adjustmens
t
ib le for su ch a st ov ed . Th e 'cl as
co pons
t. a atrs mu be rem ed by an inflow or outflow of gold wa
sre res . . 4 "An ive balance, accompa
ni
d t ac iv ; ~r pa ss e do m es tic money supply · and this
m~bamsm ts: s n or contra ct io n of th and
_re u t m an expansio level of domestic ~osts
O
fo!1llal~y suppose t a ris e or fa ll in th e
abou · the latter to
was expected to bring · · ourage exports or m
expans10n ~r co~trathcteiofonnner case to st·mm1ate un ports an d di sc d changes
·ces [Link] ' m . ,
d flo w s, ch an ge s in th e quantity of mo~ey an
pn
stimulate exports. Gol mechanism of adjustm
ents".5
diseo uz:age unports and in ci pa l fa ct or s in th e
peared as the pr countries of the world
in rel ati ve levels thus ap Th es e da ys di ffe re nt
ago.
been abandoned long r to bring the balance of
But gold standard has e gold flo w s no lo ng er oc cu
cy standard. Therefor certain modifications
are under 1:11anage~ ~~ en Recent currency experience has, however, led to duced by balance of
m. in the flow of income
in
payments mto eqmhbnu gh t th at ch an ge s lance of
in the classical theory.
It is now_ th ou
m ain po in t is th at any active or passive ba
en ts se rv e as an eq ui librating factor. "T he
e to tal flo w of m on ey income within a given
paym contract th iture
s directly to expand or of income and expend
current transaction.... tend e of pa ym en ts in th e flo w s
lance
induced by the balanc s and so react on the ba
country... The changes as ho m e- pr od uc ed go od
d for imported as6well
affect, in turn, the deman
into equilibrium". ugh either
of payments to bring it ct io ns in th e ba lance of payments thro
co rre work due to
atic adjustments or incomes do not always
However, these autom ug h ch an ge s in th e
ng es i
· n pr ices of go od s and factors or th ro
sy ste m . W he n th~ ca uses of disequilibrium
cha ties in th e e
rigidities and immobili ct ion via price and incom
thepresence of various us, then th e au to m at ic co rre
to be ,
ts are deeper and serio measures are required
in the balance of paymen umsta nc e, so m e co nc re te
payments
at all. Under such circ brium in the bal8!1,ce of
changes does not work pa ym en ts. D ise qu ili
rium in the balance of
taken to restore the equilib ing m et ho ds by the Government.
th e fo 11 ow
may be corrected by of payments :
n m etho ds fo r co rre cting adverse balance
w
There are four well-kno an d Restraining Import
s
an di ng Ex po rt s
1. Trade Policy Measu
res : E xp
pa ym en ts re fe r to ~ e measur~s ~dopted to
nce of
s to improve the bala ducmg or aboltshmg ex
port
Trade policy measure may be en co ~r ra ge d by re
couraged
duce imports. Exports rts. Expo~s are also ~n
Promote exports and re ed fo r fin an cin g ex po
wer mcom~ tax
interest rate on credit us , on export eanungs lo
duties and lowering the d ex po rte rs. Be sid es :icthes.
manufacturers an more goods an~.se1
by granting subsidies to iv
pr od uc e an
es to the exporters to b reduced to make them compettttv m
d ex po rt e e
to pr ov id e in ce nt
can be levied
I .,-I?~ ~ w er ex ci se du tie s,
•
pn ces of exports can e
~;2
'1l • •
·ng lo
. ~2~ ifm,rkets.. ,
1
. 1r .Ihid . . . -- --v-;r--;,-
 \ )

( )

( )
730 Macroeconomics : Theory and Policy
g tariffs (i.e., import dur1
. On the other hand, imports may be reduced by imposing or raisin
sing import quotas, introdu .es)
~n imports of goods. Imports may also be restricted through impo
\

.I ,)
totally prohibited. ClJlg
licences for imports. Imports of some inessential items may be
following all the above P<>li
Before tl1e economic refonns carried out since 1991 ln?ia had b~en
ve its balance of payments Positiocy
measures to promote exports and restrict imports so as to impro
balance of payments disequilibriur::
But they had ~ot achieved nuch success in their aim to correct
ce of payments. On several OCcasi
Therefore, India had to face great difficulties with regard to balan
emerge~ as a result of huge defi :
~t approached IMF to bail it out of the foreign exchange crisis that
d by persist~t defici~ in balance of
m tlle balance of payments. At long last, economic crisis cau~e
ve a long-lastmg solution of balance
payments forced India to introduce structural reforms to achie
of payments problem.
2. Expenditure-Reducing Policies
An important way to reduce imports and thereby reduce defici
t in balance of payments is to adopt
diture in the economy. The fall in
monetary and fiscal policies that aim at reducing aggregate expen
s to reduce imwrts and helps in
aggregate expenditure or aggregate demand in the economy work
of reducing aggregate expenditure
solving the balance of payments problem. The two important tools
policy. We explain them below.
are the use of ( 1) tight monetary policy and (2) contractionary fiscal
check aggregate expenditure
Tight Monetary Policy. Tight monetary policy is often used to
availability of credit. For this bank
or demand by raising the cost of bank credit and restricting the
to higher lending rates charged by
rate is raised by the Central Bank of the coutnry which leads
w for investment and consumers to
the commercial banks. This discoruages businessmen to borro
to the reduction in investment and
borrow for buying durable cosnumers goods. This therefore leads
for investment and consumption
consumption expenditure. Besides, availability of credit to lend
the banks and also undertaking of
pwposes is reduced by raising the cash reserve ratio (CRR) of
open market) by the Central Bank
open market operations (selling Government securities in the
or demand which helps in reducing
of the country. This also tends to lower aggregate expenditure
monetary policy to check imports,
imports. But there are limitations of the successful use of
monetary policy adversely affects
especially in a developing country like India. This is because tight
mic growth. If a developing counuy
investment increase in which is necessary for accelerating econo
ive in curbing inflation by reducing
is experiencing inflation, tight monetary policy is quite effect
diture and, depending on the income
aggregate demand. This will help in reducing aggregate expen
tary policy helps to reduce prices c.
propensity to import, will curtail imports. Besides, tight mone
rate will curb the tendency to import,
lower the rate of inflation. Lower price level or lower inflation
both on the part of businessmen and consumers.
sion or slowdown in economic
But when a developing country like India is experiencing reces
tary policy that reduces aggregate
growth along with deficits in balance of payments, use of tight mone
affect economic growth and deepen
expenditure or demand will not help much as it will adversely
tary policy has to be used along
economic recession. Therefore, in a developing country, mone
policy to tackle the problem of
with other policies such as an appropriate fiscal policy and trade
disequilibrium in the balance of payments.
important means ofreducing
~ Contractionary Fiscal Policy. Appropriate fiscal policy is also an
income tax will reduce aggregate
aggregate expenditure. An increase in direct taxes such as
ase in imports. Increase in indirect
expenditure. A part of reduction in expenditure may lead to decre
in expenditure. The other fiscal
taxes such as excise duties and sales tax will also cause reduction
unproductive or non-developmental
~ policy measure is to reduce Government expenditure, especially
reduce expenditure directly but also
expenditure. The cut in Government expenditure will not only
hP nnP.r~tion of multiplier.
 Balance of Payments 731
that 'f 'gh t mon,1ary a d . .
fJJP,Y be
__,.A
JW14,U i t1
n~ rac t,o na ry fis ca l po licies succeed in lowering
causes reduct · n . co
ca ft ~penditure which
,tf :~ ~o ways to improve
the ba lan ce ;c;;t ~
= e s
ts.
0~ Joweri~g the rate of inflation , they will
F1 rst , faJ J 1~ doemstic prices or lower
rate
le to buy doematic nd, Jower
• ~ i\, o wiU induce peop
o f~ priceB or lower rate balan,ee of
of inflation wi ll i' od;icts
8
im u ate
rat he r than imported goods. Seco exp<1rf8
export«J . FaJl in imports an
d rise in
"' .""1¢ ~" reducing de
ficit in payments.
.
~ Jp ~ . th ough
empbas 1U(f again that ~ me th0 d of reducing expenditure thr
t1o~eVet, it may be d fiscaJ 1\1, • • . t J' · · egate
v -- ~rv monetary an ,,,v 11c1es 1s not with ou .1mitat10ns . If reduction in aggr
ffi in balance
~ u » -J
~:ia JoWetS invbeestm ent, this will adverse! ec t ec o~ om ic growth. Thus, correction
the ex y ; reduce
p -_ ts may achieved at re P: se o economic growth . Further, it is not easy to tives
j ~ ~ Jy government ex
penditu as they are likely to affect inc
en
im po se he a~ tax es
blic an balance
~ invest and invite pu grotest ~d ?P0 sition. We thus see that correcting the
,,ort
of~ t s
through contractio ry iscal policy 1s not an easy matter.
na
PoJJde, : Devaluation
;. iipeadlture-Swftchfng fu ndamental d1•seqmh • •bri·urn m · balance
ite of ten us ed to ct
sia1:rnifica nt method which is qu • ·
corre
nd itu re-switching policies wo
rk
.
ng po lic ies . Ex pe
"
15
~e use. of ex~dttu re-switchi • g domestic • ally produced
of parments ce s Pn ·ce s f · are
· reased by makin
inc
. --,dh c'""'nges m re
lative pn •. o imports rts which
C'JV"b" UO: sw itc hin g po lic ies ma y lower the prices of expo
penchture- itching
~ relattvely cheaper. Ex s wa y by ch an gin g r~ lat ive prices, expenditure-sw
n ~ . In thi
fiIJ eocoura~e exports .of a ~seqmhbrium in balance of payments.
~ es help m correctmg d1 po lic y is the red uction in foreign exchange
rate of
nditure-sw itc hi ng or exchange
The important form of expe tio n. By de va lua tio n we mean reducing the value that
tit national currency, namely
, deva lua
oth er fo rei gn cu rre nc ies . It should be remembered
ratl of a national currenc
y with respect oo ge rat e system and occasionally
decides
de r fix ed ex ch an
country is un
devahiation is made when a rre nc y to improve its balance of
payments.
an ge rate of its cu was adopted,
to .lower the exch
m ad op ted in 19 46 , fix ed exchangerate system
the countries were allowed
Syste to
Under the Bretton Woods ba lan ce of pa ym en ts,
but to correct fundamenta l
disequilibrium in the of IM F. Now, Bretton Woods Sy
stem has
th the pe rm iss ion s
rrencies wi ir currencies and have thu
make devaluation of their cu wo rld ha ve flo ate d the
1ml abandoned and m os t
of the countries of the rce s of demand for and supply of
th em
d by ·m ark et fo
te as determine its exchange
aikJpted flexible exchange ra ch an ge rat e sy ste m, the value 'of a currency or
However, even in the presen
t flexible ex
n fal l. Fa ll in the va lue of a currency with respect
mand for and supply of it
ca eciate
rate as determined by de ec iat ion . If a co un try pe rmits its currency to qepr
described as depr us, in our
to foreign currencies is it, it wi ll ha ve the sa me effects as devaluatio11. Th
chec k t through
without taking effective steps to of faJI in v;tlue of a currency whether it is brought abou ange rate
ects ds fixed exch
analysu we will di8CU8s eff wh en In dia was under Bretton-Woo
. In Ju ly J 99 1, r dollar) to
devaluation or depreciation the extent of about 20%. (From f 20 per dollar to f 25 pe
l)'ltem it devalued its
rupee to
lance of payments. ents. As 2
correct disequilibrium in the ba luation of a currency works to impr-ove balance oi paym s of
Now the question is how de
va
c~ en cy ~i th res pe ct to foreign currencies, ~e price
ange rate of a co~g~s exports and disco
urages
ftsult of reduction in the exch of im po rts go up . Th is en
ereas prices c~ of ~yme~ts
~ to be exported fall, wh d im po rts dis co ur ag ed, the deficit m the. balan
ted an gpo/zcy
'llJJ>ons. With exports 80 stimula y of devaJuation is aJso referred to as ~p end1tu~-sw1tc~m rts to
, polic po
~Ji tend to be reduced. Thus op Je of a co un try ~w itc h tbeJI ex~nditur~ on un
imports, pe s of exports,
'11lce as a result of reduction of It may be noted that as a result of ~ e J~wenng _o f~nce > _l). And
s.
the domestically produced goodthe demand for a country's exports 1s pnce elastic (1.e., for imports
ep
-if demand
~J>ortearning, wiJJ increase ~, . the va lue of imports wiU faJI if. a
country . 's .11 . . t d
f · nse mS ea
~30I [Link] the Pia u"
· ·
". m pnces o unpofouo po rts is ine las tic , its ex penditure on imports wi
untry r im
ofe ~Jc. If demand of a co
11
f imports.
falling due to higher prices ·o
 l j

( )

( i1 732 Macroeconomics : Theory and Policy

( )
D~valuation: Marshall:Lerner Condition. It is clear fro~ ab~ve. th at whether devalua .
I
deprecrntion will lead to the rise in export earnings and reductton. m import expenditur t1on
( . . . d . e de ()t
on the pnce elasttcity of foreign demand for exports and domes~1c e~and for imports. ~ ~
and Lerner have developed a condition which states that devaluation will succeed in improvlll~tsba11
d . I . . Of .
balance of payments if sum of price elasticity of exports an pnce e aStJctty imports is °" gthe
. . bl ~eater
one. Thus, according to Marshall-Lerner Condition, deva Iuation nnproves a ance of paYln than
ents if
eX +em > 1
where e:c stands for price elasticity of exports
em stands for price elasticity of imports
If in case of a country ex + em < 1, the devaluation [Link] adversely ~ffect. ~al~nce of PaY?n
position instead of improving it. Ifex+ em= 1, devaluation will leave the disequilibrium in the balaents
of payments unchanged. llcc
Income-Absorption Approach to Devaluation. Further, for devaluation to be successful .
111
correcting disequilibrium in the balance of payments, a country should have sufficient exportab
surplus. If a country does not have adequate amount of goods and services to be exported, fall !e
~eir prices due to devaluation or depreciation will be of no avfil. This ~an be [Link] thro~
mcome-absorption approach put forward by Sidney S Alexander . Accordmg to this approach, trade
balance is the difference between the total output of goods and services produced in a country and
its absorption by it. By absorption of output of goods and services we mean how much of them
is used up for consumption and investmei;it in that country. That is, absorption means the sum of
consumption and investment expenditure on domestically produced goods and services. Expressing
algebraically we have
B = Y-A
where B- = trade balance or exportable surplus
Y = national income or value of output of goods and
services produced
A = Absorption or sum of consumption and investment
expenditure
It follows from above that if expenditure or absorption is less than national product, it will
have positive trade balance or exportable surplus. To create this exportable surplus, expenditure on
domestically produced consumer and investment goods should be reduced or national product must
be raised sufficiently.
To sum up, it follows from above thatfor devaluation or depreciation to be successful in correcting
disequilibrium in the balance ofpayments, the sum ofprice elasticities of demand for a country s
exports and imports should be high (that is, greater than one) and secondly it should have sufficient
exportable surplus. The devaluation will also not be successful in the achievement of its aim if other
countries relaliate and make similar devaluation in their currencies and thus competitive devaluation
of the exchange rate may start.
After Independence India devalued its currency three times, first in 1949, the second in J~e
1966 and third in July 1991, to correct the disequilibrium in the balance ofpayments. The devaluatt~n
?f June 1966 was not successful for some ~~e to reduce deficit in the balance of payments. Thi;
1s because the demand for bulk of our trad1t1onal exports was not very elastic and also we co~
not reduce our imports despite their higher prices. f{owever devaluation of July 1991 proved ~uit;
successful as after it our exports gre_w at a rapid rate for some years and growth of imports rematlle
within safe limits.
 .
J Balance of Payments 733
~ bange Control
a> ti'
• A,
:I_? fiJ1aIIY, there is the method of exchange controI . We know that deflation is dangerous· devaluation
·
u atemporary effect and may provoke others also to devalue. Devaluation also hits the prestige of
b95 l)lltrY· These methods
. are ' therefore , avo1"ded and mstea
· d foreign
· exchange 1s
· controlled
· by the
, co (lllllent· Under 1t' all
. .the exporters are ordered to surrender thetr· foregm
· exchange to the Centra1
aove untry and 1t 1s the
, af11' of a co . . t' d
n ra tone out among the licensed importers. None else is allowed to
~ port go~ds without a licence. The balance of payments is thus rectified by keeping the imports
~.i.;n }in11ts.
~~- .

After the Sec~nd ~?rld W~ ~ n~w i~temational institution, 'International Monetary Fund (IMF),'
set up for mamtammg eqmhbnum m the balance of payments of member countries for a short
: :. Member countries b~rrow from it for a short period to maintain equilibrium in the balance
~fpayments. IMF also adv1~es memb_er countries how to correct fundamental disequilibrium in the
i,a1ance of payme~ts when •~ does anse. It ma~, however, be mentioned here that no country now
needs to be forced mto deflation (and so depression) to root out the causes underlying disequilibrium
as bad to be done under the _gold standard. On the contrary, the IMF provides a mechanism by which
changes in the rates of foreign exchange can be made in an orderly fashion. _
Conclusion. In short, correction _of disequilibrium calls for a judicious combination of the
following methods:
(i) Monetary and fiscal changes affecting income and prices in the country;
(ii) Exchange rate adjustment, i.e., depreciation or appreciation of the home currency;
(iii) Trade restrictions, i.e., tariffs, quotas, etc.;
(iv) Capital movement, i.e., borrowing or lending abroad; and
(v) Exchange control.
No reliance can be placed on any single tool. Jbere is room for more than one approach and for
more than one device. But the application of the tools depends on the nature of the disequilibrium.
There are, we have said, three types of disequilibrium: (1) cyclical disequilibrium, (2) secular
disequilibrium, (3) structural disequilibrium (at the goods and the factor level). It is more appropriate
that fiscal measures should be used to correct cyclical disequilibrium in the balance of payments. To
correct structural disequilibrium adjustment in exchange rate should be avoided. Capital movements ·
are needed to offset deep-seated forces in secular disequilibrium.
The main methods of desirable adjustment are, therefore, monetary and fiscal policies which
directly affect income, and exchange depreciation (that is, .devaluation) which affects prices in the
first instance. Devaluation or depreciation of exchange rate can also have income effect through price
effects. Monetary and fiscal policies affect relative prices also.

--< . QutisT10Ns ,[Link]

·}
I. Distinguish between balance of trade and balance of payments.
2•.What is meant by balance of payments on current account? Explain the visible and.
invisible items on the current acco~nt.
3. Dis~guish between current account and capital account of the balance ofpayments. Mention:~
the various items on both these accounts of the balance of payments. ~
4. When is a country's balance of payments said to be in equilibrium? Explain the factors that·:
cause disequilibrium in the balance of payments. >
'1
.S. Balance -o f payments must always balance. Is it true? Explain. ~
6. What is devaluation ? Is it an effective way of correcting disequilibrium in the balance_Qft:
payments? -~
 licy
J 73 4 Ma cro eco nom ics : The ory and Po
that can be ado pte d to cor rec t·disequilibriurn ,
) ~t~,:,',~7~ '-:J hp ~~ int he :VArtous measures
<~.·
) tt\~ . 1)f the 'b ala nce
llr e-r edu
•' t :-.• ~iis,expeiidit·of payments in eqhilibrium?c:ittg. fis~ al pol icy ? Ho w doe s it hel p to ~i nta ~ the -~
, · t~eco~
the ,
·.

dev alu atio n ? Un der w.- .at con dit ion s is it exp ect ed to impr9Ve
~; :/ ' ~. Wh at is me ant by , · ,~alance
of pay me nts pos itio n ofa n eco no my ? ·
}·
n app roa ch to dev alu atio n as a me asu re of correcting bala ·
~ ' .10~ Dis cus s the abs orp tio . nee- or
.
~ '· · pay me nts def icit . icies to -
we en Ex pen dit ute -Re duc ing and Expenditure-Switching pol
-11. D
- isti ngu ish bet
d. ·1·b
1 . ·
num . , , , , ,. Correct
Ule bal
". .'L. f
. •anc e o pay me nts 1se qu1
and disadvanta~es with Spe cial reference
to
ges
- 1:22· -~:it <•· · ·-·' -
i~ glo bal isa tio n ? Bk pla itt_-i!S.
"
atlv an~
· · '
Ind
~~
ia~- '.\::"\'~.tt, ~ \~ .. , '•,,' , ·~ ,,:. ,,
. ., ~ 't ," -,;- ,, ,. '
>- "'<: