Definition of 'Balance Of Payments BOP A record of all transactions made between one particular country and all other

her c ountries during a specified period of time. BOP compares the dollar difference o f the amount of exports and imports, including all financial exports and imports . A negative balance of payments means that more money is flowing out of the cou ntry than coming in, and vice versa. Balance of payments may be used as an indicator of economic and political stabil ity. For example, if a country has a consistently positive BOP, this could mean that there is significant foreign investment within that country. It may also me an that the country does not export much of its currency. This is just another economic indicator of a country's relative value and, along with all other indicators, should be used with caution. The BOP includes the tr ade balance, foreign investments and investments by foreigners. BOP Accounts are an accounting record of all monetary transactions between a cou ntry and the rest of the world. These transactions include payments for the coun try's exports and imports of goods, services, financial capital, and financial t ransfers. The Bop accounts summarize international transactions for a specific p eriod, usually a year, and are prepared in a single currency, typically the dome stic currency for the country concerned. Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or su rplus items. Uses of funds, such as for imports or to invest in foreign countrie s, are recorded as negative or deficit items. When all components of the BOP accounts are included they must sum to zero with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counterbalanced in other ways such as by funds earned from its foreign investm ents, by running down central bank reserves or by receiving loans from other cou ntries. What are the Methods of Correcting Disequilibrium in the Balance of Payments? Persistent disequilibrium in the balance of payments, particularly the deficit b alance, is undesirable because it (a) weakens the country's economic position at the international level, and (b) affects the progress of the economy adversely. It must be cured by taking appropriate measures. There are many methods to corre ct disequilibrium in the balance of payments. Important among them are discussed below: 1. Deflation: Deflation is the classical medicine for correcting the deficit in the balance of payments. Deflation refers to the policy of reducing the quantity of money in o rder to reduce the prices and the money income of the people. The central bank, by raising the bank rate, by selling the securities in the ope n market and by other methods can reduce the volume of credit in the economy whi ch will lead to a fall in prices and money income of the people. Fall in prices will stimulate exports and reduction in income checks imports. Th us, deflationary policy restores equilibrium to the balance (a) by encouraging e xports through reduction in their prices and (b) by discouraging imports through the reduction in incomes at home. Moreover, a higher interest rate in the domestic market will attract foreign fun ds which can be used for correcting disequilibrium. However, deflation is not considered a suitable method to correct adverse balanc e of payments because of the following reasons: (a) Deflation means reduction in income or wages which is strongly opposed by the trade unions, (b) Deflation ca uses unemployment and suffering to the working class, (c) In a developing econom y, expansionary monetary policy rather than contractionary (deflationary) moneta ry policy is required to meet the developmental needs. 2. Depreciation: Another method of correcting disequilibrium in the balance of payments is deprec iation. Deprecation means a fall in the rate of exchange of one currency (home c urrency) in terms of another (foreign currency). A currency will depreciate when its supply in the foreign exchange market is lar ge in relation to its demand. In other words, a currency is said to depreciate i

f its value falls in terms of foreign currencies, i.e., if more domestic currenc y is required to buy a unit of foreign currency. The effect of depreciation of a currency is to make imports dearer and exports c heaper. Thus, depreciation helps a country to achieve a favourable balance of pa yments by checking imports and stimulating exports. Exchange depreciation is automatic: It works in a flexible exchange rate system and can correct a mild adverse balan ce of payments if the country's demand for imports and the foreign demand for it s exports are fairly elastic. But the method of exchange depreciation has the fo llowing defects: (i) It is not suitable for a country which follows a fixed exchange rate system. (ii) It makes international trade risky and thus reduces the volume of trade. (iii) The terms of trade go against the country whose currency depreciates becau se the foreign goods have become costlier than the local goods and the country h as to export more to pay for the same volume of imports. (iv) Experience of certain countries has indicated that exchange depreciation ma y generate inflationary pressure by increasing the domestic price level and mone y income. (v) The success of the method of exchange depreciation depends upon the cooperat ion of other countries. If other countries also start depreciating their exchang e rates, then these methods will not benefit any country. 3. Devaluation: Devaluation refers to the official reduction of the external values of a currenc y. The difference between devaluation and depreciation is that while devaluation means the lowering of external value of a currency by the government, depreciat ion means an automatic fall in the external value of the currency by the market forces; the former is arbitrary and the latter is the result of market mechanism . Thus, devaluation serves only as an alternative method to depreciation. Both the methods imply the same thing, i.e., decrease in the value of a currency in term s of foreign currencies. Both the methods can be used to produce the same effects; they discourage import s, encourage exports and thus lead to a reduction in the balance of payments def icit. The success of the method of devaluation depends upon the following conditions : (i) The elasticity of demand for the country's exports should be greater tha n unity. (ii) The elasticity of demand for the country's imports should be greater tha n unity. (iii) The exports of the country should be non-traditional and the increasingl y demanded from other countries. (iv) The domestic price should not rise and should remain stable after devalu ation. (v) Other countries should not retaliate by resorting to corresponding deval uation. Such a retaliatory measure will offset each other's gain. Devaluation also suffers from certain defects: (i) Devaluation is a clear revelation on the country's economic weakness. (ii) It reduces the confidence of the people in country's currency and this m ay lead to speculative outflow of capital. (iii) It encourages inflationary tendencies in the home country. (iv) It increases the burden of foreign debt. (v) It involves large time lag to produce effects. (vi) It is a temporary device and does not provide a permanent remedy to corr ect adverse balance of payments. 4. Exchange Control: Exchange control is the most widely used method for correcting disequilibrium in the balance of payments. Exchange control refers to the control over the use of foreign exchange by the central bank. Under this method, all the exporters are directed by the central bank to surrend er their foreign exchange earnings. Foreign exchange is rationed among the licen

sed importers. Only essential imports are permitted. Exchange control is the most direct method of restricting a country's imports. T he major drawback of this method is that it deals with the deficit only, and not its causes. Rather it may aggravate these causes and thus may create a more bas ic disequilibrium. In short, exchange control does not provide a permanent solut ion for a chronic disequilibrium. Balancing mechanisms One of the three fundamental functions of an international monetary system is to provide mechanisms to correct imbalances. Broadly speaking, there are three possible methods to correct BOP imbalances, th ough in practice a mixture including some degree of at least the first two metho ds tends to be used. These methods are adjustments of exchange rates; adjustment of a nations internal prices along with its levels of demand; and rules based a djustment. Improving productivity and hence competitiveness can also help, as can increasi ng the desirability of exports through other means, though it is generally assum ed a nation is always trying to develop and sell its products to the best of its abilities. Rebalancing by changing the exchange rate An upwards shift in the value of a nation's currency relative to others will mak e a nation's exports less competitive and make imports cheaper and so will tend to correct a current account surplus. It also tends to make investment flows int o the capital account less attractive so will help with a surplus there too. Con versely a downward shift in the value of a nation's currency makes it more expen sive for its citizens to buy imports and increases the competitiveness of their exports, thus helping to correct a deficit (though the solution often doesn't ha ve a positive impact immediately due to the Marshall Lerner condition). Exchange rates can be adjusted by government in a rules based or managed currenc y regime, and when left to float freely in the market they also tend to change i n the direction that will restore balance. When a country is selling more than i t imports, the demand for its currency will tend to increase as other countries ultimately need the selling country's currency to make payments for the exports. The extra demand tends to cause a rise of the currency's price relative to othe rs. When a country is importing more than it exports, the supply of its own curr ency on the international market tends to increase as it tries to exchange it fo r foreign currency to pay for its imports, and this extra supply tends to cause the price to fall. BOP effects are not the only market influence on exchange rat es however, they are also influenced by differences in national interest rates a nd by speculation. Rebalancing by adjusting internal prices and demand When exchange rates are fixed by a rigid gold standard, or when imbalances exist between members of a currency union such as the Eurozone, the standard approach to correct imbalances is by making changes to the domestic economy. To a large degree, the change is optional for the surplus country, but compulsory for the d eficit country. In the case of a gold standard, the mechanism is largely automat ic. When a country has a favourable trade balance, as a consequence of selling m ore than it buys it will experience a net inflow of gold. The natural effect of this will be to increase the money supply, which leads to inflation and an incre ase in prices, which then tends to make its goods less competitive and so will d ecrease its trade surplus. However the nation has the option of taking the gold out of economy (sterilising the inflationary effect) thus building up a hoard of gold and retaining its favourable balance of payments. On the other hand, if a country has an adverse BOP it will experience a net loss of gold, which will aut omatically have a deflationary effect, unless it chooses to leave the gold stand ard. Prices will be reduced, making its exports more competitive, and thus corre cting the imbalance. While the gold standard is generally considered to have bee n successful up until 1914, correction by deflation to the degree required by th e large imbalances that arose after WWI proved painful, with deflationary polici es contributing to prolonged unemployment but not re-establishing balance. Apart

from the US most former members had left the gold standard by the mid 1930s. A possible method for surplus countries such as Germany to contribute to re-bala ncing efforts when exchange rate adjustment is not suitable, is to increase its level of internal demand (i.e. its spending on goods). While a current account s urplus is commonly understood as the excess of earnings over spending, an altern ative expression is that it is the excess of savings over investment. That is: where CA = current account, NS = national savings (private plus government secto r), NI = national investment. If a nation is earning more than it spends the net effect will be to build up sa vings, except to the extent that those savings are being used for investment. If consumers can be encouraged to spend more instead of saving; or if the governme nt runs a fiscal deficit to offset private savings; or if the corporate sector d ivert more of their profits to investment, then any current account surplus will tend to be reduced. However in 2009 Germany amended its constitution to prohibi t running a deficit greater than 0.35% of its GDP and calls to reduce its surplu s by increasing demand have not been welcome by officials, adding to fears that the 2010s will not be an easy decade for the eurozone. In their April 2010 world economic outlook report, the IMF presented a study showing how with the right c hoice of policy options governments can transition out of a sustained current ac count surplus with no negative effect on growth and with a positive impact on un employment.