THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUEDâ€¦â€¦.):BALANCE OF PAYMENTS

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Introduction to Economics ECO401

Lesson 11.4

THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS

(CONTINUED.......)

BALANCE OF PAYMENTS

The balance of payments (BOPs) is an accounting record of a country's transactions with the

rest of the world. To illustrate the related concepts in a non-complicated way, we shall assume

a two-country world (Pakistan and the US), and view things from the Pakistani side.

Before we can fully grasp the BOPs, it is important to develop an understanding of the market

for foreign exchange. Foreign exchange, in the Pakistani context, simply means US dollars

(note that foreign exchange from the US's point of view would be Pak rupees).

The Market for Foreign Exchange:

The market for foreign exchange (or dollars) in Pakistan works like the market for any other

commodity (like apples, oranges etc.). We have an upward sloping supply curve and a

downward sloping demand curve. We operate in the same price-quantity framework, noting,

however, that quantity in this context means the quantity of dollars and price in this case

means price per dollar, i.e. the rupee price of a dollar. However, the latter is simply the

Rupee/US$ exchange rate, and hence we can label the vertical axis accordingly.

The Forces of Demand and Supply in Foreign Exchange Market:

Now, consider what the forces of demand and supply are in this market. First consider what

could cause the supply curve for dollars to shift to the right, i.e. what would cause the supply of

dollars in the market to increase given a certain exchange rate. Well, any transaction which

has the effect of bringing dollars into the country would have this effect. Examples of such

transactions are net inflows of US investment into Pakistan, Pakistani exports to the US,

remittances from Pakistanis working in the US. Now what are examples of transactions that

cause the demand for dollars to increase? Pakistani imports of US goods, Pakistani travelers

traveling to the US, Pakistani students paying for study in US universities, profits repatriated to

US by US firms operating in Pakistan. All these will cause the demand for dollars in the

market to increase.

Any transaction which causes the supply curve of dollars to shift to the right is recorded with a

positive sign on the BOPs (as it corresponds to an inflow of dollars), while any transaction

which causes the demand curve to shift to the right is recorded with a negative sign on the

BOPs.

Equilibrium in the Market of Foreign Exchange:

Equilibrium in the market for foreign exchange occurs at the point of intersection of the supply

and demand curves. In BOP terminology, this is when all the +vs and the ves balance; i.e.

the BOPs is zero (external balance).

Given an initial equilibrium, it is useful to study note how market equilibrium responds to a shift

in, say, the supply curve. A distinction has to be made between the cases when the exchange

rate is fixed by the government and when it is left to float freely.

When the exchange rate is fixed, the government has to make up for any excess or shortfall in

the market. Thus, if the supply curve shifts to the right (say due to a rise in exports), and

there is an excess supply of dollars, the government must step in and purchase those excess

dollars from the foreign exchange market, pumping the equivalent local currency in the

process. This purchase is an example of foreign exchange market intervention by government

(often implemented by the central bank on behalf of the government).

Similarly, if there is a rightward shift in the demand curve (due to, say, a rise in imports),

and there is a situation of excess demand for dollars at the given exchange rate, the

government must step in and supply those dollars from its coffers in exchange for local

currency. The government's foreign exchange reserves fall and the local currency (rupee)

supply contracts as a result of this kind of intervention.

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To let the exchange rate float freely is to allow the price mechanism to bring about automatic

equilibrium in the foreign exchange market. Thus in this case, if there is an excess supply of

dollars, the price of the dollar falls (i.e. less rupees are required to purchase one dollar). In

other words, the rupee appreciates vis-à-vis the dollar. Conversely if there is an excess

demand for dollars in the market, then this pushes the exchange rate up (i.e. more rupees will

now be needed to buy one dollar). In other words, the rupee depreciates. Note that an

increase (decrease) in the price of the dollar is equivalent to a(n) depreciation (appreciation) of

the rupee, not vice versa.

Parts of BOP:

The BOPs can be divided into three parts:

i. Current account,

ii. Capital account and

iii. Changes to reserves.

The Current account:

The current account balance is essentially the trade balance (exports minus imports), but with

net factor receipts from abroad added.

If the exchange rate is fixed, then changes in reserves must mirror the combined balance on

the current and capital accounts in order to bring the overall BOPs to zero. If the exchange

rate is floating, then changes to reserves can remain zero, as the adjustment burden is borne

by the exchange rate which appreciates (depreciates) in response to a joint surplus (deficit) on

the current and capital accounts.

External Transactions:

External transactions which have no long-term (or future) flow implications for the current

account are recorded on the current account. Thus exports, imports, and factor payments

(foreign workers' outward remittances, interest on foreign debt, and dividends on profits of

foreign firms) and factor receipts (overseas Pakistanis' inwards worker remittances, interest

earned on foreign assets held, dividends earned by Pakistani firms abroad) are all recorded on

the current account.

Compare these transactions with the taking on of a new long-term foreign debt recorded with

a plus sign under the capital account. Here, the initial inflow of dollars does not make the

transaction complete in an inter-temporal sense. The money that has come in will have to be

repaid, both principal and interest over the future. Similarly, foreign investment coming into the

country. The initial dollars coming in will imply a future stream of current account outflows in

terms of dividend remittance abroad.

In the long-term, the current account and capital account should usually mirror each

other. So if the current account is in deficit, you would expect the country to be borrowing or

attracting foreign investment on the capital account to bring the overall BOPs to zero.

Similarly, if the current account is in surplus, you would expect the country to be lending to the

rest of the world or investing outside the country.

The capital Account:

The capital account generally provides a direct picture of the net asset position of a country

vis-à-vis the rest of the world. If the capital account stays in surplus year after year, this

indicates the country's increasing indebtedness to the rest of the world. If however, the capital

account stays in deficit year after year, this means the country's indebtedness to the rest of the

world is falling.

At the introductory level, BOP problems normally refer to a deficit on the current

account, since the capital account is assumed to be passive. Thus external disequilibrium is

usually associated with a situation where the trade balance (exports imports) is in deficit.

This raises two questions:

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a. Is a current account deficit necessarily bad? The answer is no. Recalling the

condition for macroeconomic equilibrium S+T+M = I+G+X, and rearranging, we can get

{M-X} = [I-S] + (G-T). The {} term is the current account or trade balance, the [] term

gives the private sector resource deficit (i.e. the excess of the private sector's

investment over savings) and the () term is the government fiscal deficit. It is clear that

if M>X because G>T (i.e. government is spending in excess of its resources), then the

current account deficit might be unsustainable (i.e. bad), especially if the government's

spending is essentially of a current nature. However, a trade deficit which finances

private investment that would otherwise not have been possible, is likely to be

desirable, esp. if the private sector is investing in industries that will have future export

potential (because this means the country will have the foreign exchange reserves in

the future to pay off the debt that is being incurred today to finance the current account

deficit).

b. How can a current account, which is in deficit, be restored to balance? Firstly it

must be recognized that perennial current account deficits of the sort implied in the

question only obtain under fixed exchange rates (because under floating exchange

rates, the disequilibrium would self-correct through exchange rate depreciation). One

quick fix solution to sort out current account deficits under fixed exchange rate regimes

is to have an economic deflation. The theory here is as follows: when a country's

national income rises, it spends more; part of that spending falls on imported goods;

higher imports cause the current account to worsen. The reverse is also true: lower

income must reduce import spending and therefore improve the current account

spending. However, economic contraction is a rather painful way of restoring current

account equilibrium. A less painful one suggested by economists is devaluation, the

name given to exchange rate depreciation but in the context of fixed exchange rates.

(The corresponding term for exchange rate appreciation is revaluation.) A devaluation

attempts to bring the exchange rate in line with its long-run equilibrium level, i.e. a level

consistent with international competitiveness. Competitiveness is simply defined as the

real exchange rate (RER), where RER = (Pf/Pd)*NER; NER is the nominal exchange

rate (in Rs/$), Pf is the price level prevailing in the foreign country (US), and Pd is the

price level prevailing in the home country (Pakistan). The formula simply says that,

given a fixed NER, if inflation is higher in Pakistan (relative to the US), Pakistani

exports will become less attractive (or competitive) in the international market. As a

result, our exports will fall, and current account will go into deficit. To rectify the

situation, the NER can be devalued so as to make our goods cheaper and bring

competitiveness back to its original higher level. However, there are many provisos

attached to the devaluation policy prescription. Devaluation only works if the country's

exports and imports are elastic, otherwise the price effect of the devaluation will

dominate the volume effect and the current account will worsen. Secondly, the country

must have excess productive capacity in order to meet the higher demand for exports

that is created as a result of the devaluation. Thirdly, the country should not have a

very high foreign debt whose burden increases so much as a result of the devaluation

that the negative effects associated therewith overwhelm any positive competitiveness

effects.

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