In other cases, the price may be set above the equilibrium price – leading to excess supply and a surplus. There are several factors which cause disequilibrium in the BOP indicating either surplus or deficit. With respect to revenue increases, administrative improvements have generally been given preference over increase in rates. In this case, the government is essentially borrowing from the taxpayers, but the tax payments so received are not considered as financing. In view of the instability of exchange policy during the period, expressing all the values in the same currency requires extremely painstaking calculations. As it was not possible to complete such work for this occasion, the figures presented must be considered merely as a very crude approximation of the variables in question.
Likewise, if her demand for imports is elastic, then the imports of the country will be significantly reduced by devaluation, which in turn would improve the balance of payments of the devaluing country. Owing to a fall in aggregate demand, prices also fall, so that the country becomes a good market to buy from and a bad market to sell in. In this way, imports get discouraged and exports are stimulated, thus correcting the adverse balance of payments. But deflation is not types of disequilibrium in balance of payment a healthy method, because the reduction of money incomes hits business, trade and industry hard and brings about depression and unemployment. The important way to reduce imports and thereby reduce deficit in balance of payments is to adopt monetary and fiscal policies that aim at reducing aggregate expenditure in the economy. The fall in aggregate expenditure or aggregate demand in the economy works to reduce imports and help in solving the balance of payments problem.
A balance of payments disequilibrium can occur when there is an imbalance between domestic savings and domestic investments. A deficit in the current account balance will result if domestic investments is higher than domestic savings since the excess investments will be financed with capital from foreign sources. In addition, when the trade agreement between two countries affects the level of import or export activities, a balance of payments disequilibrium will surface. After the Second War World a new international institution’ International Monetary Fund (IMF)’ was set up for maintaining equilibrium in the balance of payments of member countries for a short term.
Second, lower domestic prices or lower rate of inflation will stimulate exports. Fall in imports and rise in exports will help in reducing deficit in balance of payments. The connection between financing of the deficit and monetary expansion (normally referred to as inflationary finance) can come in several ways. First, the central bank may buy government bonds directly, in which case monetary expansion is immediate. Second, the government may sell bonds to the public, including the commercial banks, and the central bank may in turn buy the bonds from the public. In this case, the connection between financing of the deficit and monetary expansion is not as immediate and direct as in the previous case, but the end result is the same.
- M. Keynes’s thought to the development of modem economic theory has been the central role he assigned to fiscal policy in stabilizing output.
- For analytical purposes the financing of the deficit can be distinguished in different ways, all important, but emphasizing different aspects.
- Similarly, when the balance of payments deficit gets smaller or the balance of payments surplus gets trigger the balance of payments is said to ‘improve’ and in the opposite case, there is ‘deteriorates’.
- As a result, the people tend to import less and their demand for home-produced goods too becomes less, releasing more of them for exports.
If price fluctuations take the form of business cycle, most countries face depression and inflation almost simultaneously. Since economic size of the nations differs, their imports are affected in varying degrees. Deficits and surpluses in https://1investing.in/ the balance of payment vary from moderate to large. The countries with higher marginal propensity to import accumulate larger deficits during inflationary phase of trade cycle and a moderate deficit or even surplus, during depression.
Since this mechanism implies, in general, an increase in the money supply, it tends to create an excess of liquidity in the hands of the public. In addition, the pressure put by excess liquidity on the level of prices has an additional equilibrating effect by reducing the real value of the outstanding money stock. The two mainstreams of analysis of the effects of fiscal expansion on the balance of payments are the monetary model of the balance of payments and the more traditional macroeconomic models based on the Keynesian framework. The interaction of these two effects would determine the balance of payments outcome.
However, a short-run disequilibrium may also emerge if a country’s imports exceed its exports in a given year. • Fall in Export Demand – UDCs are exporting mainly primary products, such as agriculture product. But in the international market the demand for the primary product falls.
The magnitude of the deficit or surplus is the central piece in the determination of the levels of aggregate demand, income, prices, and, eventually, in an open economy, of the balance of payments. A disequilibrium in the balance of payments whether a deficit or surplus has important implications for a country. A deficit in the combined current and capital accounts is regarded as undesirable for the country. This is because such a deficit has to be covered by borrowing from abroad or attracting foreign exchange or capital from abroad.
Deficit in current account as % of GDP
Such changes incapacitate exporting countries and they find it difficult to face competition in the international market, due to either high cost of production or lack of foreign demand. Further, it is not easy to reduce substantially government expenditure and impose heavy taxes as they are likely to affect incentives to work and invest and invite public protest and opposition. We thus see that correcting the balance of payments through contractionary fiscal policy is not an easy matter. India had been following all the above policy measures to promote exports and restrict imports so as to improve its balance of payments position.
But the excess of imports over exports may be financed by foreign investments in the country. These may lead to increased production, employment and income in the country. In the long-run, foreign investors may purchase large assets in the country and thus adversely affect domestic industry as is the case with MNCs (multinational corporations). The reason being that a current account deficit is the same thing as a capital account surplus. However, it is beneficial for a country to have a current account deficit even if it equals capital account surplus in BOP. In the short-run, the country may benefit from a higher level of consumption through import of goods and consequently a higher standard of living.
Types of Disequilibrium (With Diagram)
The important form of expenditure switching policy is the reduction in foreign exchange rate of the national currency, namely, devaluation. By devaluation we mean reducing the value or exchange rate of a national currency with respect to other foreign currencies. It should be remembered that devaluation is made when a country is under fixed exchange rate system and occasionally decides to lower the exchange rate of its currency to improve its balance of payments.
We seem to be far less certain today than we were in the 1960s about how to answer that question.4 Because of this, the U.S. Council of Economic Advisers has suspended the calculation of potential income. In conclusion, while one may be able to define, in theory, a structural deficit, it is nevertheless very difficult to agree on its measurement. Cyclical fluctuations in business activity also lead to BOP disequilibrium.
What is an unfavourable BoP?
The graph at the top of the chart shows the different behavior of the two groups in the context of Peru’s current inflationary process. On one side, Group A shows systematic increases in the levels of demand, expressed by the upward shift of its demand curve D1–4. In addition, its supply curve S1–4 shifts to the left as nominal costs rise. Disequilibrium is a result of a mismatch between the market forces of supply and demand. The mismatch is generally resolved through market forces or government intervention.
The level of international reserves will clearly be affected much less in this case. The first and the major cause of disequilibrium in the balance of payment is the change in the price level. The balance of payments surplus does not cause a serious concern from the country’s point of view. It may, however lead to wasteful expenditure and mal-allocation of resources. On he other hand, inflationary changes in prices causes deficits in the balance of payments.
In July 1991, when India was under Bretton-Woods fixed exchange rate system, it devalued its rupee to the extent of about 20%. (From Rs. 20 per dollar to Rs. 25 per dollar) to correct disequilibrium in the balance of payments. In order to maintain a country’s sound economic condition, its disequilibrium in balance of payment position (if any) must be corrected. Otherwise if the situation continues for a long, the country will exhaust its foreign exchange reserves. A surplus in the balance of payments occurs when the inflows of foreign currency, such as from exports, foreign investments, or borrowing, exceed the outflows, such as imports, capital outflows, or repayment of foreign loans. A surplus implies that the country is a net creditor to the rest of the world.
Structural Changes and Disequilibrium
But they had not achieved full success in their aim to correct balance of payments disequilibrium. Under exchange control, all the exporters are directed to surrender their foreign exchange to the central bank or to sell it at the official rate to the government. Then it is rationed out among the licensed importers i.e., the government will allocate the scarce foreign exchange among the importers on the basis of some non-price criteria. Fund programs generally contain statements of goals or objectives in relation to improvement in (1) the balance of payments, (2) growth performance, and (3) the rate of inflation. At times a reduction of payment arrears and economic diversification have also been specified as a program’s objectives. Most programs mention balance of payments improvement, and many programs specify growth and the improvement in the fiscal accounts.