IGNOU : M.COM : IBO 1 : UNIT 3 : Q - 2. What is balance of payment? Explain the factors affecting the balance of payments.

Ans.  Balance of payment is an accounting record of the transactions between the residents of one country and the residents of the rest of the world over a given period of time. Transactions in which domestic residents either purchase assets (goods and services) from abroad or reduce foreign liabilities are considered uses (out flow) of funds because payments abroad must be made. Similarly, transactions in which domestic residents either sell assets to foreign residents or increase their liabilities to foreigners are sources (inflows) of funds because payments from abroad are received. Thus, in a way, it resembles a company's sources and uses of funds statement.

FACTORS AFFECTING BALANCE OF PAYMENTS

The Current Account

A country's current account balance can significantly affect its economy, therefore, it is important to identify the factors that influence it. The most important factors are:

 i) Inflation

ii) National Income

iii) Government Restructures

iv) Exchange Rates.

 Let us discuss them one by one.

Inflation : If a country's inflation rate increases relative to the countries with which it trades, its current account would be expected to decrease. Due to higher prices at home, consumers and corporations with in the country will most likely purchase more goods overseas (due to high local inflation), while tile country's exports to other countries will decline.

National Income : If a country's national income rises by a higher percentage than those of other countries, its current account is expected to decrease, other things being equal. As the real income level (adjusted for inflation) rises, so does consumption of goods. A percentage of that increase in consumption will most likely reflect an increased demand for foreign goods.

Government Restrictions : If a country's government imposes a tax on imported goods (often referred to as a tariff) the prices of foreign goods to consumers effectively increases. An increase in prices of imported goods relative to goods produced at home will discourage imports and is expected to increase the current account balance. In addition to tariffs, a government may reduce its imports by enforcing a quota, or a maximum limit on imports.

Exchange Rates : Each country's currency is valued in terms of other currencies through the use of exchange rates, so that currencies can be exchanged to facilitate international transactions, The values of most currencies can fluctuate over time because of market and government forces, If a country current account balance decreases, other things being equal, goods exported by the country will become more expensive to the importing countries, if its currency strengthens, as a consequence, the demand for such goods will decline. For example, a refrigerator selling in the United State for $ 100 require a payment of Rs. 3500, if the dollar were worth Rs. 351- Ks. 1 = $0.028). Yet, if the dollar were worth Rs. 401- (Rs. 1 = $ 0.025), it would take Rs, 4000 to buy the refrigerator. which could discourage Indians to buy it, However, according to J-curve theory, a country's trade deficit worsens just after its currency depreciates because price effects will dominate the effect on volume of imports in the short run. That is the higher costs of imports will more than offset the reduced volume of imports. Thus, the J curve theory states that a decline in the value of home currency should be followed by a temporary worsening in the trade deficit before its longer term improvement.

The Capital Account

As with the current flows, government policies affect the capital account as well. A country's government could, for example, impose a special tax on income account by local investors who invested in foreign markets. A tax would discourage people from sending their funds for investment in the foreign markets and could therefore, increase the country's capital account. Capital flows are also influenced by capital controls of various types. Interest rates also affect the capital flows. A hike in interest rates relative to other countries may affect capital inflows from abroad. Similarly, a reduction in domestic rates may induce people to invest abroad.

The anticipated exchange rate movements by investors in securities can affect the capital account. If a home currency is expected to strengthen, foreign investors may be willing to invest in the country's securities to benefit from the currency movement. Conversely, a country's capital account balance is expected to decrease, if its home currency is expected to weaken, other things being equal.

When attempting to assess why a country's capital account changed and how it will change in future, all factors must be considered simultaneously. A particular country may experience a reduction in capital account even when its interest rates are attractive, if the home currency is expected to depreciate.