INTERNATIONAL ECONOMICS II

[Econ 2082]

CHAPTER THREE

BALANCE OF TRADE AND

BALANCE OF PAYMENT

Wondesen M. (MSc)
 OUTLINES
YOUR LOGO

Introduction on Balance of Balance of Payments

01 Payments 04 Surplus or Deficit

02 The Concept of Balance of

payments
05 Balance of payment
adjustment

03 Balance of payments
accounting and accounts
06 BOP CRISES

Wondesen M. (MSc) [email protected] 2

 3
3.1. Introduction on Balance of Payments

 The balance of payments is a statistical record of all the economic

transactions between residents of the reporting country and residents of the
rest of the world during a given time period.

 The usual reporting period for all the statistics included in the accounts is a
year. However, some of the statistics that make up the balance of
payments are published on a more regular monthly and quarterly basis.

 Without question the balance of payments is one of the most important

statistical statements for any country.
Cont’d 4

 It reveals how many goods and services the country has been exporting and
importing, and whether the country has been borrowing from or lending
money to the rest of the world.

 In addition, whether or not the central monetary authority (usually the central
bank) has added to or reduced its reserves of foreign currency is reported in
the statistics.

 A key definition that needs to be resolved at the outset is that of a domestic

and foreign resident. It is important to note that citizenship and residency is
not necessarily the same thing from the viewpoint of the balance-of-
payments statistics.
 The term “resident” comprises , households, firms and the public authorities.
Cont’d 5

 Some problems that arise with respect to the definition of a resident:

✓ Multinational corporations are by definition resident in more than one country.
For the purposes of balance-of-payments reporting, the subsidiaries of a
multinational are treated as being resident in the country in which they are
located even if their shares are actually owned by foreign residents.

✓ Another problem concerns the treatment of international organizations such as

the IMF, the WB, UN, and AU.... These institutions are treated as being foreign
residents even though they reside in USA and Ethiopia, respectively.

✓ Tourists are regarded as being foreign residents if they stay in the reporting
country for less than a year.

 Purchases and sales between residents of the same country are excluded.
 6
3.2. The Concept of Balance of payments

National Income Accounting -

▪ Measures national performance of the economy: domestic transaction
▪ Records all expenditures that contribute to income and output
▪ Records all final goods and services produced in a given period
Balance of Payments Accounts -
▪ Measures national economic performance relative to other nations.
▪ Records international transaction.
▪ Shows macroeconomic linkage between different countries.
▪ Shows international indebtedness & performance of export & import substituting firms.
▪ Relates foreign transaction and the monetary changes.
 7
3.2.1. The National Income Accounts (NIAs)

 GNP is of a central interest for macroeconomists in NIAs. GNP is the value of

all final goods and services produced by its resources sold in the market in a
given time period.

 It is measured by adding up the monetary value of all expenditures on the

final output in a given period of time.

 The expenditures that make up GNP are closely related to employment of

labor, capital and other factor inputs.

 GNP contains three types of product purchase spending: consumption,

investment and public purchase.
 8
Cont’d

 The current account balance is instead foreign produces of our resources net
of all exports to the external world.

 Dividing GNP in to its components is vital to enable us understand the sources

of economic recession or boom.

 Knowing how each GNP category changes, we are able to make sound
policy proposals and thus interventions.

 The NIAs provide essential information as to why some nations are richer than
others or have higher GNP. GDP may not include output produced by
national factor inputs in the rest of the world.
 9
Cont’d

 GDP may not give the full picture of national economic performance.

 The NIA, not output accounting, can be thought of as classification of a

transaction based on the category of the expenditure or income that it gives
rise to. Change in aggregate output demand changes economic
performance.

 Change in economic performance must be related to either of the

categories of aggregate demand.

 Hence, dividing AD or GNP in to its components is crucial to identify the

source of change in economic performances.
 10
National Product and National Income

 GNP a country generates equals national income earned. Every dollar used
to purchase G&S in an economy automatically ends up in somebody’s
pocket.

 The sell of product involves the payment of all factors of production that
cooperated in producing it in varied form.

 The payments may include wages, salaries, incomes, interests, dividend,

rent, profits and other possible forms.

 Only the sell of final products are considered in GNP to avoid double
counting in case of intermediates products.
 11
Capital Depreciation, International Transfers and IBTs

 Some adjustments to definition of GNP must be made so that equality of

GNP and income practically is correct.

 GNP doesn't include depreciation-the economic loss due to machinery and

structure wear out when used over time.

 Depreciation reduces the income of capital owners and GNP minus

depreciation gives the net national product. NNP = GNP − 𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏

 GNP excludes unilateral transfers that include pension, reparation and relief
funds from foreign countries.
Cont’d 12

 Net unilateral transfer is part of its income but not its product and must be
added to NNP to compute income.

 National income is based on the prices sellers receive while GNP depends
on the prices that purchasers do pay.

 Indirect business taxes are sources of differences that overestimate income

and should be reduced from GNP.

 National income thus equals GNP less depreciation plus net unilateral
transfers and less indirect business taxes.

NNP = GNP − 𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 + net unilateral transfers - indirect business taxes

 Gross Domestic Product (GDP) 13

 Most countries consider GDP statistic instead of GNP as their primary

measure of the national economic activities.

 GDP is supposed to measure economic activities or the volume of goods

and services within a country’s borders.
𝑮𝑵𝑷 = 𝑮𝑫𝑷 + NFI (Net factor income)
NFI = Factor income received – Factor income paid to abroad

 GDP doesn't correct for the portion of a country’s output produced through
services provided by a foreign capital.

 However, GNP tracks national income more closely than GDP and national
welfare lies more closely on GNP than GDP.
 National Income Accounting for an 14
Open Economy
 The open economy NIA links national saving, investment and trade
imbalances.

 Consumption spending: consumer goods purchase by households to fulfill

current wants. It is the largest component of GNP in most economies.

 Investment spending: the part of output used by firms to produce future

goods and services. Investment spending is used to raise the stock of
capital. Firms purchase of inventories is are part of investment spending.

 Government Purchases: all Gs & Ss purchased by federal, state or local

government in national accounts. Government transfer payments are not
included in GNP. Investment is more variable than consumption spending.
 15
The National Income Identity for Open
Economies
 In a closed economy, all output is either consumed by households, invested
and purchased by the government. If foreign trade is possible, some output
is purchased by foreigners and spending goes to purchase foreign output.

 The GNP identity for open economy shows how national income is divided
among sale to nationals and foreigners.

 Domestic GNP excludes part of income spent on imports and includes the
Gs & Ss sold to foreigners. The open economy GNP is sum of domestic and
foreign expenditure on output produced by domestic resources.

Y= C + I + G is a NIA identity for a closed economy

Y= C + I + G + NX(= EX−IM) is an identity for a Open economy
 16
3.2.2 Balance of payments accounting
and accounts
 An important point about a country's balance-of-payments statistics is that
in an accounting sense they always balance. This is because they are
based upon the principle of double-entry book-keeping.

 Each transaction between a domestic and foreign resident has two sides to
it, a receipt and a payment, and both these sides are recorded in the
balance-of-payments statistics.

 Each receipt of currency from residents of the rest of the world is recorded
as a credit item (a plus in the accounts) while each payment to residents of
the rest of the world is recorded as a debit item (a minus in the accounts).
 17
Cont’d

 The Balance of Payments (BP): like national income accounts, economists/

statiscians keep balance of payment accounts (BPA).

 The BPA are detailed record of the composition of the current account
balance and transactions that finance it.

 The BPA capture of great interest to the general public which inform us the
implications of global transactions.

 The BPA keeps track of both its receipts and payments.

 A payment-to-foreigners and receipt-from foreigners are recorded in the

BPA as ‘debit’ and ‘credit’ respectively.
 18
Cont’d

 Three types of transactions are often recorded in the BPA.

▪ Transactions that involve the import or export of output.

▪ Transactions that involve the purchase or sell of financial assets

recorded in the financial account (FA) balance.

▪ Certain other activities resulting in the sell and purchase or transfer of

wealth recorded in the capital account. These result from non-market
activities, or disposal or gain of non-produced, nonfinancial and
intangible assets.
 19
Cont’d

 Let us consider the various sub accounts that make up the balance
of payments.

 Traditionally, the statistics are divided into two main sections:

▪ The current account (items in this part refer to income flows)

▪ The capital account (items in this part refer to records on changes in

assets and liabilities of the country)

 Each part is further sub divided into sub-accounts.

 20

A) Current account

 The Current Account: is a country’s net export of output in which import

payments enter the BP in a negative sign.

 Imports and exports of goods and services consist of

✓ merchandise,

✓ service, and

✓ income payments and receipts.

Cont’d 21

 The CAB in turn contains

✓ imports,
✓ exports &
✓ the net unilateral current transfers.
 The CA is the difference between the value of nation’s total exports
and imports of Gs & Ss.

 When exports exceed imports, we say there exist a CA surplus but if

imports exceed there will be a CA deficit.
 22
Cont’d

 The open economy identity reveals importance of CA in international

macroeconomics: output and employment. It virtually affects
domestic production and employments.

 The CA balance shows change in net foreign wealth/debt.

 A deficit CAB may imply a high expenditure that may or may not result
in increment in production capacity.

We can write the CA as

CA = Y- C-I-G.
Cont’d 23

 A country has a CA deficit or uses output more than its

produces;
▪ If it borrows or import of future consumption.
▪ if its GNP is less than its expenditure.
 A country has a CA surplus or use output less than its
produces;
▪ if it exports or exports present consumption.
▪ if its GNP exceeds its domestic expenditure.
 24
Saving and Current Account

 Saving and investment are different in open economy unlike closed

economy case.
 An open economy can save by either building up stock of capital or
by acquiring foreign wealth: S = I + CA
 A country’s current account surplus is considered as a net foreign
investment because it has to be repaid later date.
 The borrowing country pays back to net foreign investor from the part
of its future income that will be generated.
 25
Cont’d

 A country can utilize domestic and/or foreign investment so as to use

current savings to increase its future income.

 Private and Government Saving: public saving decision is often based

on its effect on output and employment.

 The national income identity helps us analyze channels through

which the Government Saving affects macroeconomic conditions.
 26
Cont’d
 The private saving is the part of  The national income identity
national income & disposable can be rewritten to show
income is income less of the net effects of government saving
taxes. decision in open economy.

 The private saving can thus be 𝑺𝒑 + 𝑺𝒈 = CA + I

expressed as: 𝑺𝒑 = 𝒀 − 𝑻 − 𝑪. ⇒ (Y−T−C) + (T−G) = CA + I
⇒ 𝑺𝒑 = 𝐂𝐀 + 𝐈 − 𝑺𝒈
 Government saving is the
difference between its tax
𝑺𝑷 = CA+ I - (T-G)
revenue and its expenditure
expressed as: 𝑺𝒈 = 𝐓 − 𝐆.
𝑺𝑷 = CA + I + (G-T)
 27
Cont’d

 Private saving is a function of domestic investment, government saving and

current account surpluses as well; 𝑺𝑷 = CA + I + (G-T)

 Budget deficit may directly or inversely relate to CAB based on the effect of
a particular policy on other variables in the equation.

 When budget deficit falls, private saving may fall and vice versa.

 The government deficit (G-T) above shows the extent of government

borrowing to finance its domestic spending.
 28
Cont’d

 Private saving thus lies on the level of domestic saving, extent of

wealth purchase from foreigners and new debts.
 The current account can be divided into two sub accounts:
▪ visible and
▪ invisible accounts.
 The visible records the values of imported and exported goods,
 the invisible sub-account records values of imported and exported
services; interests, profits and dividends received/paid; unilateral
receipts and payments.
 29
Cont’d

 The balance on the visible accounts of the current account is termed as the
trade balance.

Trade Balance = Receipts for exported goods – Payments on imported Gs.

Current account balance = Trade balance + invisible balance

 The trade balance is sometimes referred to as the visible balance as it

represents the difference b/n receipts for exports of goods and expenditure
on imports of goods which can be visibly seen crossing frontiers.

 When the trade balance is in surplus this means that a country has earned
more from its exports of goods than it has paid for its imports of goods.
 30
Cont’d

The invisible balance shows/includes:

a)receipts and payments of services such as
▪ shipping,
▪ tourism,
▪ insurance and banking

b) receipts and payments of interest, dividends and profits,

c)Unilateral
transfer: payments or receipts for which there is no
corresponding quid pro quo (something for something else).
 31
Cont’d
 Unilateral transactions are ;
▪ migrant workers' remittances to their families back home,
▪ the payment of pensions to foreign residents, and
▪ foreign aid.
 It’s redistribution of income between domestic and foreign residents.
 Unilateral payments can be viewed as a fall in domestic income due
to payments to foreigners and so are recorded as a debit.
 Unilateral receipts can be viewed as an increase in income due to
receipts from foreigners and consequently are recorded as a credit.
 32
B) Capital account

 The capital account records transactions concerning the movement of

financial capital into and out of the country.
 Capital comes into the country by
▪ borrowing,
▪ sales of overseas assets, and
▪ investment in the country by foreigners.
 These items are referred to as capital inflows and are recorded as
credit items in the balance of payments.
 33
Cont’d

 Capital inflows are, in effect, a decrease in the country's holding of

foreign assets or increase in liabilities to foreigners.

 The fact that capital Inflows are recorded as credits in the balance of
payments often presents students with difficulty.

 Capital Account Balance = Capital Inflows – Capital Out flows.

 Similarly investment by foreign residents is the export of equity or

bonds, while sales of overseas investments is an export of those
investments to foreigners.
Cont’d 34

Capital leaves the country due to

▪ lending,
▪ buying of overseas assets, and
▪ purchases of domestic assets owned by foreign residents.

 These items represent capital outflows and are recorded as debits.

 Capital outflows are, in effect, an increase in the country's holding of

foreign assets or decrease in liabilities to foreigners.

 they represent the purchase, the purchase of foreign bonds or equity,

and the purchase of investments in the foreign economy.
 35
Cont’d

 Items in the capital account are normally distinguished according to

▪ whether they originate from the private or public sector, and

▪ whether they are of a short-term or long-term nature.

 The summation of the capital inflows and outflows as recorded in

the capital account gives the capital account balance.
𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝒊𝒏𝒇𝒍𝒐𝒐𝒘 + 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝒐𝒖𝒕𝒇𝒍𝒐𝒘 = 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝒂𝒄𝒄𝒐𝒖𝒏𝒕 𝒃𝒂𝒍𝒂𝒏𝒄𝒆
 36
C) Official settlements balance

 Given the huge statistical problems involved in compiling the

balance-of payments statistics,

 there will usually be a discrepancy between the sum of all the items
recorded in the current account, capital account and the balance of
official financing (see table 2.1) which in theory should sum to zero.

 To ensure that the credits and debits are equal it is necessary to

incorporate a statistical discrepancy for any difference between the
sum of credits and debits.
Cont’d 37

 There are several possible sources of this error:

a. it is an impossible task to keep track of all the transactions; many of the
statistics are based on sampling estimates derived from separate
sources, so that some error is unavoidable.

b. the desire to avoid taxes means that some of the transactions in the
capital account are underreported.

c. Dishonest firms may deliberately under-invoice their exports and over-

invoice their imports to artificially deflate their profits.

d. Another problem is that of 'leads and lags’. - it can happen that a good
is imported but the payment delayed.
Cont’d 38

 The summation of the CAB, KAB and the statistical discrepancy gives
the official settlements balance.
 The balance on this account is important because it shows the
money available for adding to the country's official reserves or
paying off the country's official borrowing.
 A central bank normally holds a stock of reserves made up of foreign
currency assets.
 Such reserves are held primarily to enable the central bank to
purchase its currency should it wish to prevent it depreciating.
 39
Cont’d

 Any official settlements deficit has to be covered by the authorities drawing

on the reserves, or borrowing money from foreign central banks or the IMF
(recorded as a plus in the accounts).

 If, on the other hand, there is an official settlements surplus then this can be
reflected by the government increasing official reserves or repaying debts
to the IMF or other sources overseas (a minus since money leaves the
country).

 The fact that reserve increases are recorded as a minus, while reserve falls
are recorded as a plus in the balance-of-payments statistics is usually a
source of confusion.
Cont’d 40

 It is most easily rationalized by thinking that reserves increase when the

authorities have been purchasing foreign currency because the domestic
currency is strong.

 This implies that the other items in the balance of payments are in surplus, so
reserve increases have to be recorded as a debit to ensure overall
balance.

 Conversely, reserves fall when the authorities have been supporting a

currency that is weak; that is, all other items sum to a deficit so reserve falls
must be recorded as a plus to ensure overall balance.
 41
Table 3.1. The balance of payments of a hypothetical country
 42
Cont’d
 43
Cont’d
 44
3.3. Balance of Payments Surplus or Deficit

 the balance of payments always balances since each credit in the

account has a corresponding debit elsewhere.

 However, this does not mean that each of the individual accounts that
make up the balance of payments is necessarily in balance; for instance,
the current account can be in surplus while the capital account is in deficit.

 When talking about a balance-of-payments deficit or surplus economists

are really saying that a subset of items in the BoP is in surplus or deficit.

 Economists make a distinction between autonomous (above the line items)

and accommodating (below the line) items.
 45
Cont’d

 Autonomous are transactions that take place independently of the balance

of payments.

 Accommodating items are those transactions which finance any difference

between autonomous receipts or payments.

 A surplus in the balance of payments is defined as a excess of autonomous

receipts aver autonomous payments.

 Deficit is an excess of autonomous payments over autonomous receipts.

▪ Autonomous receipts > autonomous payments = surplus
▪ Autonomous receipts < autonomous payments = deficit
Cont’d 46

It is not easy to identify autonomous and accommodating:

 For example, if there is a short-term capital inflow in response to a higher

domestic interest rate, it should be classified an autonomous item.

 If, however, the item is an inflow to enable the financing of imports then it
should be classified as an accommodating item.

 The difficulty of deciding which items should be classified as

accommodating and autonomous has led to several concepts of balance-
of-payments disequilibrium.
 47
Cont’d

❖ A surplus in the BOP implies that the demand for the country’s
currency exceeded the supply and that the government should
allow the currency value to increase – in value – or intervene and
accumulate additional foreign currency reserves in the Official
Reserves Account.

❖ A deficit in the BOP implies an excess supply of the country’s currency

on world markets, and the government should then either devalue
the currency or expend its official reserves to support its value.
 48
3.3.1. Alternative Concepts of Balance of Payments
Surplus and Deficits

a) The trade account and current account

 These two accounts derive much of their importance because
estimates are published on a monthly basis by most developed
countries.

 Since the current account balance is concerned with visible and

invisibles, it is generally considered to be the more important of the two
accounts.
Cont’d 49

 a surplus means that the country as a whole is earning more than its spending
relative to the rest of the world and hence is increasing its stock of claims on
the rest of the world;

 while a deficit means that the country is reducing its net stock claims on the
rest of the world.

 Furthermore, the current account can readily be incorporated into economic

analysis of an open economy.

 More generally, the CA is likely to quickly pick up changes in other economic

variables such as changes in the real exchange rate, domestic and foreign
economic growth and relative price inflation.
 50
b) The basic balance

 The basic balance is the Current account balance plus the net balance
on long-term capital flows.

 The basic balance was considered to be particularly important during the

1950s and 1960s period of fixed exchange rates because it was viewed as
bringing together the stable elements in the balance of payments.

 It was argued that any significant change in the basic balance must be a
sign of a fundamental change in the direction of the balance of payments.

 The more volatile elements such as short-term capital flows and changes in
official reserves were regarded as accommodating items.
Cont’d 51

 Although a worsening of the basic balance is supposed to be a sign of a

deteriorating economic situation, having an overall basic balance deficit is
not necessarily a bad thing.

 For example, a country may have a current account deficit that is

reinforced by a large long-term capital outflow so that the basic balance is
in a large deficit.

 However, the capital outflow will yield future profits, dividends and interest
receipts that will help to generate future surpluses on the current account.

 Conversely, a surplus in the basic balance is not necessarily a good thing.

Cont’d 52

 A current account surplus which is more than covered by a net capital

inflow so that the basic is in surplus could be open to two
interpretations.

a) It might be argued that because the country is able to borrow long run
there is nothing to worry about since it regarded as viable by those
foreigners who are prepared to lend it money in the long run.

b) Another interpretation could argue that the basic balance surplus is a

problem because the long-term borrowing will lead to future interest,
profits and dividend payments which will worsen the CA deficit.
Cont’d 53

 Apart from interpretation, the principal problem with the basic balance
concerns the classification of short-term and long-term capital flows.

 The usual means of classifying long-term loans or borrowing is that they be

of at least 12 months to maturity.

 However, many long-term capital flows can be easily converted into short-
term flows if need be.

 For example, the purchase of a five-year US treasury bond by a UK investor

would be classified as a long-term capital outflow in the UK balance of
payments and long-term capital inflow in the US balance of payments.
 54
Cont’d

 However, the UK investor could very easily sell the bond back to US investors
any time before its maturity date.

 Similarly, many short-term items with less than 12 months to maturity

automatically get renewed so that they effectively become long-term assets.

 Another problem that blurs the distinction between short-term and long-term
capital flows is that transactions in financial assets are classified in
accordance with their original maturity date.

 Hence, if after four and a half years a UK investor sells his five-year US treasury
bill to a US citizen it will be classified as a long-term capital flow even though
the bond has only six months to maturity.
 55

c) The official settlements balance

 The official settlements balance focuses on the operations that the

monetary authorities have to undertake to finance any imbalance in the
current and capital accounts.

 With the settlements concept, the autonomous items are all the current and
capital account transactions including the statistical error,

 while the accommodating items are those transactions that the monetary
authorities have undertaken as indicated by the balance of official
financing.
 56
Cont’d
 The current account and capital account items are all regarded as being
induced by independent households, firms, central and local government
and are regarded as the autonomous items.

 If the sum of the current and capital accounts is negative, the country can
be regarded as being in deficit as this has to be financed by the authorities
drawing on their reserves of foreign currency, borrowing from foreign
monetary authorities or the IMF.

 A major point to note with the settlements concept is that countries whose
currency is used as a reserve asset can have a combined current and
capital account deficit and yet maintain fixed parity for their currency
without running down their reserves or borrowing from the IMF.
 57
Cont’d

 The official settlements concept of a surplus or deficit is not as relevant to

countries that have floating exchange rates as it is to those with fixed
exchange rates.

 This is because if exchange rates are left to float freely the official settlements
balance will tend to zero because the central authorities neither purchase nor
sell their currency, and so there will be no changes in their reserves.

 If the sales of a currency exceed the purchases then the currency will
depreciate, and if sales are less than purchases the currency appreciates.

 The settlements concept is, however, very important under fixed exchange
rates because it shows the amount of pressure on the authorities to devalue or
revalue the currency.
 58
Cont’d

 Under a fixed exchange-rate system a country that is running an official

settlements deficit will find that sales of its currency exceed purchases, and
to avert a devaluation of the currency authorities have to sell reserves of
foreign currency to purchase the home currency.

 Although in 1973 the major industrialized countries switched from a fixed to

floating exchange-rate system,

 many developing countries continue to peg their exchange rate to the US

dollar and consequently attach much significance to the settlements
balance.
 59
3.4. BOP and exchange rates

 A country’s BOP can have a significant impact on the level of its

exchange rate & vice versa.

 Under a fixed exchange rate system, the government bears the

responsibility to ensure that the BOP is near zero.

 Under a floating exchange rate system, surpluses/deficits influence

exchange rate.
 60
3.5. Balance of payment adjustment

 The BOP is a double entry system of accounts in which the sum of the
current account, the capital account and the ORB was zero. Since the BOP
must balance CA + KA + ∆RFX = 0.

CA + KA = – ∆RFX

 For floating rate regime countries, such as the U.S., official reserves are
relatively unimportant.

 The identity CA + KA = – ∆RFX assumes that all transactions are measured

accurately.

 For BOP to balance, CA + KA + E&O = – ∆RFX.

 61
Cont’d
 Assuming changes in official reserves, errors are approximately zero:
Current Account = (–) Capital Account. This will hold approximately for
floating rate countries.

 If we have a CA surplus then it will be offset by either a capital account

deficit or an ORB deficit as the excess income is lent out to foreigners by
either the government or by private individuals.

 The converse story where CA deficits were accompanied by KA or ORB

surpluses also held true.

 The adjustment process by which these shortfalls or surpluses in the CA are

reflected in surpluses or shortfalls in the KA or in the ORB is varies depending
on whether the economy has a fixed or a flexible exchange rate system.
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3.5.1. BOP adjustment under a flexible
exchange rate regime

 Suppose that ETH imports birr 700 million worth of goods and exports birr 300
million worth of goods all under 90 day trade credit.

 In 90 days time, ETH has to find a way to pay for the extra birr 400 million
worth of foreign currency in expenditure: it has to either borrow new loans
from abroad, sell assets to foreigners or divert some of their holdings of
foreign currency to pay their bills.

 Suppose that after 90 days, private individuals in ETH have only raised birr
200 million worth of foreign currency through sales of assets, new borrowing
and reducing holdings of foreign currency.

 This implies that they still need to come up with birr 200 million worth of
foreign currency.
 63
Cont’d

 One way is to turn to the government and obtain birr 200 million worth of
foreign currency from the government. However, recall that under a truly
flexible ER, the central bank doesn’t attempt to influence the exchange rate.

 As a result, we can think of the central bank as not holding any foreign
currency reserves under a flexible exchange rate regime.

 At this point, we have a BOP imbalance, i.e. CA+ KA +ORB = −400 + 200 + 0 ≠0.

 However, this imbalance does not last very long. Individuals and firms will turn
to the foreign exchange market to get their hands on foreign currency. As a
result the DD for foreign currency would rise, and the birr would depreciate.
 64
Cont’d

 The depreciation of birr raises the relative price of foreign goods and lowers
the relative price of ETH goods.

 As a result, ETH will tend to export more and import less - the CA deficit will
shrink.

 Similarly, foreigners will be much more likely to buy ETH assets because of
their relative cheapness; there will be more money flowing into the country
from foreigners buying our assets the KA surplus will increase.

 So the process of exchange rate depreciation leads to more exports, fewer

imports and greater capital inflow.
 65
Cont’d
 This allows individuals and firms in the domestic economy to get their hands
on the vital foreign currency they need to pay back the birr 200 million
worth of foreign currency in loans.

 In fact, the depreciation will continue as long as there is a greater demand

for foreign currency.

 We would expect there to be equilibrium at some intermediate level, say

CA + KA + ORB = −300 + 300 + 0 = 0 or CA + KA + ORB = −250 + 250 + 0 = 0,

 in other words a CA deficit that is less than birr 400 million and KA surplus
that is greater than birr200 million worth of foreign currency.
 66
2.5.2. BOP adjustment under a fixed
exchange rate regime

 Suppose that ETH imports 700 million birr worth of goods and exports 300
million birr worth of goods all under 90 day trade credit.

 In 90 days time, ETH has to find a way to pay for the extra 400 million birr
worth of foreign currency in expenditure: it has to either borrow new loans
from abroad, sell foreign assets or use some of their holdings of foreign
currency.

 Suppose that after 90 days the private individuals in ETH have only raised
200 million birr worth of foreign currency through sales of assets, new
borrowing and reducing holdings of foreign currency.
 67
Cont’d
 This implies that they still need to come up with 200 million birr worth of foreign
currency.

 In a flexible exchange rate system, we said that individuals and firms will turn
to the foreign exchange market for the foreign currency.

 In a fixed exchange rate regime, individuals and firms can turn to the
government and obtain the 200 million birr worth of foreign currency from the
government.

 The amount of foreign currency reserves held by the government will fall by
200 million birr, i.e. the ORB will be 200 million birr. Notice that the BOP is in
balance: CA + KA + ORB = -400 + 200 + 200 = 0.
 68
Cont’d
 Conversely, suppose that ETH imports 300 million birr worth of goods and
exports 700 million birr worth of goods all under 90 day trade credit.

 In 90 days time, foreigners have to find a way to pay for the extra 400 million
birr in expenditure: they have to borrow new loans from ETH, sell their assets to
ETH, or use some of their holdings of birr.

 Suppose that after 90 days the private individuals and firms in the rest of the
world have only raised 200 million birr,- they still need to come up with 200 mill

 Under a Fixed ER individuals and firms will turn to the National bank of Ethiopia
for the extra 200 million birr-Eth holdings of f/x reserves would increase and
their holdings of birr would decrease i.e. the ORB will be -200 million birr.

 Notice that the BOP is in balance: CA + KA + ORB = 400 - 200 - 200 = 0.

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3.6. BOP CRISES
 Occasionally countries face a situation in which there is a shortfall in the
amount of foreign currency needed to finance its external obligations, i.e.
CA + KA < 0. This shortfall will result in an increased DD for foreign currency.

 Under flexible exchange rates, this will lead to a depreciation of the

currency, which will eliminate the shortfall and allow the domestic economy
more access to foreign exchange, in other words the depreciation will
continue until CA + KA = 0.

 Under fixed exchange rates this shortfall will lead to a reduction in foreign
exchange reserves.

 However, in some cases the shortfall may be too large to be offset by a

reduction in reserves: in this case a country will face a BOP crisis.
 70

END OF CHAPTER THREE

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