Question

Describe the balance of payments and what it seeks to measure. Describe the three accounts included and what these measure. Explain how an understanding of the balance of payments helps to have a more complete of exchange that takes between nations rather than focusing on the balance of goods and services. Discuss the relationship between the current account and savings, investment, and government finances. Is the current account in itself the best measure of unsustainable trade imbalances? Explain why or why not.

Answer 1

Ans: Balance of Payments (BoP) is a statement of all the transactions made between entities in one country and the rest of the world. These transactions consist of imports and exports of goods, services and capital as well as transfer payments such as foreign aid and remittances. It measures the inflow and outflow of foerign investment, measures the extent to which transfer payments are received, services or investments are received or made etc.

The three accounts it include are the following:

(a) Current Account: Current account represents a country's imports and exports o goods and services, payments made to foreign investors and transfers such as foreign aid and remittances. The positive current account balance indicates that cpuntry is a net lender, while a current account deficit decreases it by the amount of deficit, the country is a net borrower.

Current Account = (X-M) + NY + NCT

where X= exports of goods and services

M = imports of goods and services

NY = Net earnings from abroad  

NCT = Net transfer payments.

(b) Capital Account: It records the net change of net assets and liabilities during a particular year. It reflects the inflow and ouflow of capital. The components of capital account include foreign investment and loans, banking and other forms of capital, as well as monetary changes. A positive capital account means there is inflow of money or capital or investment into the country wheras negative account indicates that there is outflow of money.

Capital Account = Change in foreign ownership of domestic assets - Change in the domestic ownership of foreign assets. It includes :

• Mostly capital transfers.
• Sale/ Transfer of patents,copyrights, franchises etc.

(c) Financial Account : It measures the differences between the sales of financial assets to foreigners and purchase of assets held abroad. It includes:

• Net balance of Foreign Direct Investment Flows (FDI)
• Net balance of portfolio flows ( inflow and outflowof debt and equity)
• Balance of Banking Flows
• Reserve Account Flows

The balancing item of overall BoP is estimated errors and omissions which include changes to the reserves of gold and foreign currency.

BoP balance = Current Account Balance + Capital Account Balance + Financial Account Balance + Balancing item ( Errors and omissions)

The complete understanding of BoP helps us to understand the equilibrium in the market of country's currency. Quantity of currency demanded = demand for exports + demand for domestic assets

Quantity of currency supplied = demand for imports + domestic demand for foreign assets

Quantity of currency demanded = Quantity of Currency Supplied

Exports + foreign purchases of domestic assets = imports + domestic purchases of foreign assets

Exports - Imports = (domestic purchase of foreign assets) - ( Foreign purchase of domestic assets)

If the above equation holds true then any current account surplus is matched by capital account deficit. This holds true when currency market is in the equilibrium. The BoP accounts teels about goods, sevices, investments, transfers and all wheras the current account only tells us about the trade of goods and services.

Current Account (CA) surplus means that country saves more thanthe investment needs.

CA = Savings - Investment

CA basically measures howmuch investment and savings have been done by the country.

CA = X- M + Net income from Abroad

CA= GNP - (C+I+G)

CA = S - I.

It tells us whether how the government is financing its purchases and how it is financing the deficit to spend more on the infrastructure and all.

The CA is not the best measure of unsustainable trade imbalances because CA only tells usabout the goods and services related payment and investment. It does not tells us about the assets and liabilities, The CA is not good measure of measuring trade imbalances only becayse it suffers from statistical discrepancies.