Balance of Payments Accounts - Essay Example

?Introduction Balance of Payments accounts for the overall level of transactions a country conducts with the rest of the world during a year. Over the period time, however, it has also gained considerable level of political significance and underlies the overall economic efforts of a country to make the economy more open to the external world. It has therefore also become a policy problem for not only the governments but also for the economists to underline a systematic approach to tackle the issue of balance of payment disequilibrium. (Kenen, 2000) The interrelationship between the balance of payments and the exchange rate regimes is one of the key relationships in economics. Since balance of payments accounts have to be balanced therefore a change in the exchange rate between the domestic and foreign currencies can actually create the balance. In order to re-balance the accounts the overall adjustment in the exchange rate regime of the country can play significant role. Thus equilibrium in balance of payments accounts could be achieved through subsequent adjustment of the exchange rates in the economy. There are however, different approaches underlying the balance of payments and it’s interlinking with the exchange rate regimes. The traditional analyses through IS-LM framework, monetarist approach as well as structural approaches are the key economic analysis frameworks underlying the issue of balance of payments. This paper will therefore attempt to discuss and explore the exchange rate regimes and the viability of the alternative approaches to resolve the balance of payments issues faced by the economies over the period of time. Balance of Payments and Exchange Rates Before discussing alternative approaches and their viability in resolving the balance of payment issues, it is critical to discus and set the theoretical foundations of the balance of payments and it’s interlinking with exchange rate regimes. Balance of payments is considered as the set of accounting records recording transactions done by the residents and non-residents in a country. Non residents are often considered as the entities located outside the borders of a country however, they exclude the subsidiaries of residents of the country located outside the borders of the country. The overall purpose is to keep the record of the flow of goods, services and capital moving to and from the country.( Krugman & Obstfeld, 2009) There are two parts of the balance of payments accounts i.e. current and capital account and both sum to zero at the end of period. Current account shows all the trade and factor income includes exports, imports whereas the factor income side includes both the payments and the earnings. The capital account however records the changes in the capital asset base of a country thus the changes in the assets of the country take place when domestic and foreign assets of the country change hands. It is also argued that the major changes in the balance of payments arise due to the changes in the capital account. (Beko ,2003). It is the movement in the capital that potentially explains the changes which take place in the balance of payment as well as the exchange rate of a country. Balance of payments Crisis Balance of payment however, can become a significant issue as at the macroeconomic level, it tends to create important political implications. Balance of payments crisis can emerge when a country is actually unable to pay for its essential imports or cannot service its debt comfortably. This normally occurs owing to the changes in the exchange rate of a country which can register a sharp decline in value during the crisis.( Hallwood & MacDonald, 2000). Apparently such crisis emerge when countries initially experience heavy capital inflows however, after a certain point, considering the overall risk associated with the international debt, investors tend to withdraw their capital in haste thus putting pressure not only on the balance of payments accounts of a country but also on its exchange rate. Capital outflows in large quantities therefore can create pressure on the exchange rates and thus overall balance in the accounts can be disturbed. (Claassen, 1996) One of the adjustment mechanisms for the balance of payment crisis is the adjustment of exchange rates. The adjustment in the exchange rates however, depends upon the different exchange rate regimes adapted by a country. All subsequent adjustment mechanisms therefore depend upon what kind of exchange rate regime has been adapted by a country. (Gibson, 1996) It is also important to note that different approaches to adjusting the balance of payments issues outline relatively different mechanisms for linking the adjustment of foreign exchange rate. The overall viability of the alternative regimes of avoiding balance of payments issues therefore has to be judged from the perspective of exchange rate regimes. Alternative Approaches There are different alternative approaches to address the issue of balance of payment crisis outlining different treatments to resolve the issue. Traditional Approach The traditional approach is based upon the adjustment in the IS-LM framework and outline different policy options available to adjust BoP. This approach however is based upon the fixed exchange rate regime under which rates are assumed to be fixed. This was due to the fact that this approach was developed in times when only fixed exchange rate regimes were in place.( June, 1989). Under the expenditure switching policies adapted under this approach, a country can actually engage into the devaluation as well as revaluation or appreciation and depreciation of the currency. Since traditional approach is based upon the notion of fixed exchange rates therefore authorities can intervene in the economy in order to correct the imbalances arising in the balance of payments of a country.( Machlup , 2003). One of the key policy options available under this approach therefore is the deliberate devaluation of the currency against other currencies in order to discourage the imports and encourage the development of import substitution in the domestic economy. Through this process, imports are made expensive and the exports are made cheaper in order to improve the trade balance of the country.( McCombie, & Thirlwall, 1994) The overall viability of this approach however, may not be entirely feasible as the overall adjustment mechanism may take time and the net results may not be as expected. Monetarist Approach The overall monetarist approach is based on the assumption that the adjustment in the balance of payments can be influenced through studying the changes in the stock, demand and supply for money. Thus any imbalances in the balance of payments are considered as the disequilibrium in the money markets of the economy and by changing money market variables; balance of payments crisis could be corrected. (McCallum, 1996). Under this approach, a free floating exchange rate regime is considered to be feasible for correcting the disequilibrium in the market. The basic equation under this approach outline that CA + KA = Change in R Accordingly, it is believed that any deficit in the current account has to be financed through the changes made in the capital account. However, this could only be achieved when exchange rate regime in practice is based on free floating system. This would therefore not require the government to make an intervention in the economy by changing the reserves and hence leave the correction process to the market forces. (Thirlwall, & Gibson, 1992) It is also important to understand that one of the major assumptions under this approach is based upon the purchasing power parity. As such the deliberate devaluation of the currency may result into the equivalent increase in the domestic prices. The devaluation of the currency will ensure that the domestic process is determined according to the world prices. As such the free floating exchange rate regime would be much better to achieve the equilibrium in balance of payments.( Winters, 1992) One of the key advantages of the free floating exchange rate over the fixed exchange rate regime, in terms of correcting the balance of payments issue, is that it releases the constraints on the balance of payments and the achieve the economic growth. Further, it can help to achieve both the internal as well as external balance simaltenousely and can allow the government to actually forget the balance of payments problems. This is due to the fact that the self correcting mechanism of the market forces would allow the adjustment in the exchange rate and make the necessary changes to bring in the equilibrium in the foreign exchange market. (Wang, 2009) Structural Approach The structural approach is often applied to the developing countries however; developed countries also frequently use this policy option. Balance of payment crisis in such economies emerges due to the structural deficiencies in the economic infrastructure of the country. The exports of the country become price inelastic whereas imports become price elastic. This therefore makes it relatively difficult for the economies to keep pace with the world economy and the underlying changes taking place in the key economic variables at the global level. (Visser, 2004). Though a free floating and managed exchange rate regime is followed mostly under this approach however, depreciation of the currency could only provided temporary relief to the country to correct disequilibrium in the balance of payments. Depreciation of the currency also results into the domestic inflation because expenditure switching and expenditure reduction techniques are used. It is also important to note that under this approach, government can also impose import restrictions in order to control the flow of foreign exchange from the country.( Williamson, & Milner, 1991) This approach can only be viable under different conditions when an economy is facing structural problems and it may not be possible for the market forces to actually make a self correction so rapidly. Though a no particular exchange rate regime is followed under this approach however, managed float is often exercised as the policy option. Under this mechanism both the depreciation as well as devaluation takes place thus allowing both the government as well as the market forces to interact and make corrections into the exchange rates to adjust the balance. It is also critical to note that most important policy option available to the policy holders is under monetarist approach. Monetarist approach seems to be most viable approach to present a self correcting mechanism for avoiding the balance of payments crisis. Conclusion Adapting different exchange rate regimes under different approaches to correct the disequilibrium in the balance of payments is one of the most important policy options available. The interlinking relationship between the free floating exchange rate regime and the balance of payments is most viable in the sense that the overall correcting mechanism is left at the market forces. Since the value of the currency is determined by the relative forces of demand and supply therefore the self correction mechanism of balance of payments largely depends upon the overall competitiveness of a country’s economy as compared to external world. Referencing 1. Beko, J, (2003). The Validity of the Balance-of-Payments--Constrained Growth Model for a Small Economy in Transition: The Case of Slovenia. Journal of Post Keynesian Economics, (26/1), 69-93 2. Claassen, E-M. (1996) Global Monetary Economics, Oxford: Oxford University Press. 3. Gibson, H. (1996) International Finance: exchange rates and financial flows in the international financial systems, Harlow: Longman. 4. Hallwood, P & MacDonald, R, (2000). International money and finance. 1st ed. London: Wiley-Blackwell. 5. June, F, (1989). International monetary economics, 1870-1960: between the classical and the new classical. 3rd ed. Cambridge: Cambridge University Press. 6. Kenen, P. (2000) The International Economy, Cambridge: Cambridge University Press. 7. Krugman, P.R. and Obstfeld, M. (2009) International Economics, London: Pearson Addison-Wesley. 8. Machlup , F , (2003). International Monetary Economics: Collected Essays. 2nd ed. London: Routledge 9. McCallum, B, (1996). International monetary economics. 1st ed. Oxford: Oxford University Press. 10. McCombie, J.S.L. and Thirlwall, A.P. (1994) Economic Growth and the Balance-of-Payments Constraint, London: Macmillan. 11. 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