Macro Economics

Session 1: Understanding the performance of a country

Learning Objectives

To measure economic performance of a country To define macro aggregates To understand the methods for measuring macro aggregates

Measures of Economic Performance

Economic Measures

Non-Economic Measures

Growth (GDP) Inflation Unemployment Balance of Payments Exchange Rate

Quality of Life Environment Health Education

Economic Growth (GDP)

Potential Growth the overall capacity of the

economy (i.e. what the economy could produce if it used all its resources)

Actual Growth the annual percentage

increase in output

Nominal Growth the growth in output at

current prices i.e, the price reigning at the time of the measurement

Real Growth growth in GDP adjusted to take

account of changes in the price level expressed as constant prices
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Inflation

A persistent rise in prices in an economy over a period of time Note: this does not mean that all prices must be rising during a period of inflation some prices may even be falling; but the general trend must be upward It is a process of rising prices & not a state of high prices
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The two main theories of inflation

The Demand-Pull inflation originates from demand side of the economy

If aggregate monetary demand for domestic output exceeds the value of the full employment output at current prices, then the price level will rise

The Cost-Push inflation originates from supply side of the economy

It is caused by rising cost of production independently of the excess demand in the market

Unemployment

This is defined as a state of affair when in a country there are a large number of ablebodied persons of working age who are willing to work but cannot find work at the current wage levels

Types of Unemployment

Three main types: Frictional unemployment Structural unemployment Cyclical unemployment

Balance of Payments

A nations BOP is a summary statement of all its economic transactions with the rest of the world during a given year. Each transaction is entered in the BOP as a credit or a debit. A credit transaction is one that leads to the receipt of a payment from foreigners while a debit transaction leads to a payment to foreigners. The main components of BOP are Current account Capital account Official reserve account
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Nominal Exchange Rates

Nominal exchange rates between two

currencies can be quoted in one of two ways:

As the price of the domestic currency in terms of the foreign currency. As the price of the foreign currency in terms of the domestic currency.

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Types of exchange rates

There are two ways the price of a currency can be determined against another. Accordingly there are two types of exchange rate: A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A floating/flexible exchange rate is determined by the private market through supply and demand
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Macroeconomic Aggregates

Important concepts

GNP & NNP (market price & factor cost) GNP & GDP Real GDP/GNP & Nominal GDP/GNP Personal disposable income

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Gross National Product (GNP)

GNP is the aggregate money value of all final goods & services produced in the economy in a given time period (quarter or year)

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Gross Domestic Product

It is the aggregate money value of all final goods and services produced within the domestic boundary of a country in a given time period (quarter or year) It is GNP what the citizens of the reporting country earn abroad + what the foreigners earn in the reporting country
GDP = GNP (what citizens of the reporting country earn abroad - what foreigners earn in the reporting country) GDP = GNP (Net Foreign Earnings)
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Net National Product (NNP)

NNP is the aggregate money value of all final goods & services produced in the economy in a given time period (quarter or year) net of depreciation*. It is defined as GNP minus depreciation.

NNP = GNP - Depreciation

Depreciation is a measure of the part of GNP that would have to be set aside to maintain the economys productive capacity

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Some derivations

GNPFC = GNP MP Net Indirect taxes NNPFC = GNPFC depreciation

National Income (NI) NNPFC

= GNPMP - Net Indirect taxes* - Depreciation
MP Market Prices FC Factor Cost *Net Indirect Taxes = (Taxes Subsidies)

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Nominal GDP & Real GDP

Nominal GDP measures the value of output at the prices prevailing in the period during which the output is produced i.e. it is measured at current prices. Real GDP measures the output produced in any one period at the prices of some base year. It implies an estimate of the real or physical change in production or output between any specified years. This can be obtained from nominal GDP by dividing nominal GDP by the corresponding price index number (omitting the multiplicative constant 100) .
Real GDP = Nominal GDP/ Price Index Number
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Personal Income (PI)

Personal Income is the sum of all incomes actually received by the individuals or households during the accounting period. It is different from NI because a part of the aggregate income earned do not reach households or individuals while some incomes received by households are not earned or at least currently earned. So from NI we deduct incomes earned but not received by households on account of social security contributions, corporate income taxes, undistributed profits & add to NI transfer payments like old age pensions, unemployment allowances, relief payments, interest payments on public debt etc
PI = NI Social security contributions Corporate income taxes Undistributed Profits + Transfer payments
19 19

Personal disposable income(PDI)

The whole amount of personal income cannot be used by individuals or households belonging to the country. A part of it is paid to the government in form of personal taxes like income tax, personal property taxes etc. There may also be some personal non-tax payments like fines, penalties etc. By subtracting these tax and non-tax payments from PI what we get is called PDI
PDI = PI Personal taxes & non-tax payments
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Allocation of Personal disposable income

PDI is the amount households have available to spend or save. The largest outlay is for personal consumption (C) the remainder is saved (S) Small amounts are also used to make interest payments & transfer payments

PDI shows how much of the value of g & s produced in an Country reach the households- who receives the GDP
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Measures of National income

Three methodsIncome method Output Method Expenditure method

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Income method

It gives national income as aggregate of all incomes generated in the nation Income of only residents of the nation (individual & corporate) who participate in current production Transfer payments are excluded Stocks adjusted Net factor income from abroad included
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Output/ Value Added method

Valuing all final goods & services produced in an economy Normally value added at each stage of production is calculated & added The NFI is then added

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Expenditure Method

Aggregates all money spent by private citizens, firms & the government Expenditures on all intermediate goods are excluded Expenditures on indirect taxes and imports excluded Subsidies added Exports added Net factor income from abroad
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Difficulties

Non-market production Imputed values Underground economy Double counting

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Macroeconomics
Session 2: Goods & Money Market

Circular flow of income

Let us for the time being assume a simple economy which has no government and is closed. The economy has only two sectors: Households & Firms
Goods & services Payment for goods & services

Households

Firms

Factor services (land, labour, capital & organization) Payments for factor services (rent, wages, interest & profits)

Refer next slide for complete diagram

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Payment for imports Abroad Imports

Imports & pay for exports

Exports & pay for imports Pay for imports & borrowings Transfer payments Government Borrowings & imports Payment for goods & services & subsidies

Payments for goods & services

Taxes (T)

Goods & services

Firms Households Factor inputs (land, labour, cap, org)

Factor incomes (rent, wager, interest, profits) Y Yd = Y - T = C+S

Interest rate (deposit rate) Interest rate (lending rate)

Demand & time deposit

Banks

Loans Reserves CRR, SLR, repo rate Securities & Gold Bond Mkt.

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GROSS DOMESTIC PRODUCT (GDP)

It is the aggregate money value of all final goods and services produced within the domestic boundary of a country in a given time period (quarter or year)

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GDP- who buys it?

Who creates the demand for the aggregate goods & services produced in an economy? Or, What are the components of Aggregate demand for the goods & services? Consumption spending by households (C) Investment spending by business & households (I) Government purchase of goods & Services (G) Net Exports (X-M)

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Consumption (C)

Chief component of demand Household spending

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Investment (I)

Gross private domestic investment Associated with business sectors adding to the physical stock of capital, including inventories It is gross in the sense that depreciation is not deducted It is domestic in the sense that this is investment spending by domestic residents & not spending on goods produced within the country

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Government (G)

Government (G) as a component of aggregate demand refers to government purchases of goods & services

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Net Exports (X-M)

The total demand for goods produced by a country includes exports of that country The total demand excludes imports of the country The difference between exports (X) & imports (M), called Net Exports is a component of aggregate demand

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The composition of GDP

GDPMP = C + I + G+ X-M
Where MP denotes Market Price

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GDP in an expanded form

Y = C (Y T) + I (Y, i)+ G + X (Y*, E) M (Y, E)

Where, Y is the countrys income, T is the tax, r the interest rate, Y* the foreign income and E the exchange rate

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Product/Goods Market equilibrium

Y = C (Y T) + I (Y, i)+ G + X (Y*, E) M (Y, E)

This equation also represents the Goods Market equilibrium condition. The LHS shows the Aggregate supply (AS) in the economy & the RHS shows the Aggregate demand (AD) in the economy
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Problem encountered in determining product market equilibrium with I(i)

The equilibrium value of Y cannot be determined without knowing the equilibrium value of i Qs: How is equilibrium i determined?

Note: assume E, the exchange rate is given

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Determination of i

In Keynes liquidity preference theory of interest equilibrium i is determined by demand for & supply of money

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Supply of & demand for money

Let nominal money supply (M0) & general price level (P) be given. So real money supply is
Ms/P

The Keynesian demand for money function/liquidity preference function is

Md/P = L1(Y) + L2 (i) = L (Y,i)

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Explanation of terms in demand function

L1(Y) demand for active real balances L1(Y) > 0 L2 (i) demand for idle (or speculative) cash balances in real terms L2(i) < 0 (so long r is higher than a certain minimum rate i min but lower than a certain maximum rate i max)

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Explanation of terms in demand function

The minimum rate of interest i min is called the floor rate at this rate demand for real speculative balances is perfectly interestelastic At i max at which demand for real speculative balances is zero L(i) < 0 so long as i lies between the two extreme rates
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Money market equilibrium

The equilibrium is given by the equality of supply of real money balances to the demand for it
Ms/P = L (Y, i) = L1(Y) + L2(i)

In the equilibrium equation there are two unknowns Y & i. So equilibrium value of i will depend on the level of Y given the L (Y, i) there are different equilibrium values of i at different levels of income Y
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Problem at hand

To determine the equilibrium level of income (Y) it is necessary to know equilibrium rate of interest (i) And to know equilibrium rate of interest (i) it is necessary to know equilibrium level of income (Y) This necessitates simultaneous determination of equilibrium values of i & Y

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Openness of an economy

Openness has three distinct dimensions:

o o o

Openness in goods markets. Openness in financial markets. Openness in factor markets.

Note: we shall discuss openness in goods & financial market only

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Openness in goods market

When goods markets are open, domestic consumers must decide not only how much to consume and save, but also whether to buy domestic goods or to buy foreign goods.

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Demand for Domestic Goods/Product market

Closed economy

Y = C + I +G
Where C = (Y-T) is consumption which is a direct function of disposable income I = I (Y, r) is investment which is a direct function of income/production Y and indirect function of real interest rate r G = autonomous
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Demand for Domestic Goods/Product market

Open economy

Y = C + I +G + X - M

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Determinants of exports (X)

X = X (Y*,E)
( , )
Exports are a part of foreign demand that falls on domestic goods. They depend on Foreign income Y*. Higher Y*, higher exports and so on. So X is a direct function of Y* Exchange rate E. Higher the price of domestic goods in terms of foreign goods, lower would be foreign demand for the good that is lower would be exports and so on. So X is an indirect function of E
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Determinants of Imports

M = M (Y,E) ( , )

M is the part of the domestic demand falling on foreign goods

An increase in domestic income, Y leads to an increase in imports. So M is a direct function of Y An increase in exchange rate leads to an increase in imports M. So M is a direct function of E
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Demand for Domestic Goods in expanded form

Y = C (Y T) + I (Y, i)+ G + X (Y*, E) M (Y, E)

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Exchange rate

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Nominal Exchange Rate (E)

Nominal exchange rates between two currencies can be quoted in one of two ways:

As the price of the domestic currency in terms of the foreign currency. As the price of the foreign currency in terms of the domestic currency.

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Nominal Exchange Rate (E)

Let the nominal exchange rate (E) be defined as the price of the foreign currency in terms of the domestic currency (as done in India).

An appreciation of the domestic currency is an increase in the price of the domestic currency in terms of the foreign currency, which corresponds to a decrease in the exchange rate. A depreciation of the domestic currency is a decrease in the price of the domestic currency in terms of the foreign currency, or a increase in the exchange rate.
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How is E determined?

Exchange rate (E) as has been defined is the price of foreign currency in terms of domestic currency Like the price of any commodity, it is also determined by the forces of demand and supply in foreign exchange markets

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Supply curve of currency

The supply curve of a currency derives from a countrys demand for imports.

This is because when paying for imports that are invoiced in foreign currency, the countrys residents must sell their currency for the needed foreign exchange; and when imports are invoiced in domestic currency, the foreign recipient of the currency sells it.
In either case, imports result in the countrys currency being supplied The amount of currency supplied = the value of imports
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Demand curve of currency

The demand curve for a currency shows the value of the currency that is demanded at each possible exchange rate. Because the need to buy a countrys currency stems from the need to pay for the countrys exports, the currencys demand curve is derived from the countrys export supply curve, which shows the quantity of exports at each price of exports The amount of currency demanded = the value of exports
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Equilibrium Exchange Rate

Exchange rate E (Re/$)

S$
R1

The equilibrium exchange rate is that at which the quantity of currency supplied equals the quantity demanded.

R0
R2

D$.
Q0

Demand and supply of dollars

Note: as E falls US becomes a cheaper and more attractive place for buying and investing. So, D$ increase and hence D$ is downward sloping. While As E increases the US finds India more attractive for buying and investing in. So S$ is upward rising.

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From Bilateral to Multilateral Exchange Rates

Bilateral exchange rates are exchange rates between two countries. Multilateral exchange rates are exchange rates between several countries. For example, to measure the average price of Indian goods relative to the average price of goods of Indian. trading partners, we use the Indian share of import and export trade with each country as the weight for that country, or the multilateral real Indian exchange rate.

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Openness in Financial Markets

Openness

in financial markets allows: Financial investors to diversifyto hold both domestic and foreign assets and speculate on foreign interest rate movements. Allows countries to run trade surpluses and deficits. A country that buys more than it sells must pay for the difference by borrowing from the rest of the world.

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The Choice Between Domestic and Foreign Assets

The decision whether to invest abroad or at

home depends not only on interest rate differences, but also on your expectation of what will happen to the nominal exchange rate.

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Financial market/Money market

Closed economy: People have demand for two financial assets: money & bond

M/P = L1 (Y) + L2 (i)

Transaction demand Speculative demand

L1 (Y) this is a direct function of Y L2 (i) this is an indirect function of i

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Openness in Financial market/Money market

Open Economy An additional consideration is: Now people have a choice between domestic bonds & foreign bonds

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Domestic Bonds Vs Foreign Bonds

Assumption: Investors always go in for the highest expected rate of return The above implies that in equilibrium both domestic bonds & foreign bonds must have the same expected rate of return; otherwise investors would be willing to hold only one or the other but not both Thus, the following arbitrage relation- interest parity condition must hold:

(1 + it) = (1 + it*) (Et/(Eet+1)

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Explaining the equation

(1 + it) = (1 + it*) (Et/(Eet+1)
Where

rt domestic interest rate rt* foreign interest rate Et current exchange rate Eet+1 future expected exchange rate
The LHS of the equation gives the return, in terms of domestic currency form holding domestic bonds & the RHS gives the expected return, also in terms of domestic currency from holding foreign bonds.
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The interest parity condition rewritten

Let the expected future interest be taken as given & denoted by Ee and dropping the time subscripts we get

E = (1 + i) Ee / (1 + i*)

Thus, the current exchange rate depends on the domestic interest rate, on the foreign interest rate and on the expected future exchange rate
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Limitations
The assumption that financial investors will hold only the bonds with the highest expected rate of return is obviously too strong, for two reasons:

It ignores transaction costs. It ignores risk.

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The interest parity condition rewritten

The

relation between the domestic nominal interest rate, the foreign nominal interest rate, and the expected rate of depreciation of the domestic currency may be stated as:

1 +it = (1+it*)/[1 + (Eet+1 Et)/Et]

A good approximation of the equation above is given by:

it~ it* - (Eet+1 - Et)/Et

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Interest Rates and Exchange Rates

it~ it* - (Eet+1 - Et)/Et

This is the relation you must remember: Arbitrage implies that the domestic interest rate must be (approximately ) equal to the foreign interest rate plus the expected depreciation rate of the domestic currency.

If

Eet+1= Et ,

then it = it*

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Question

Suppose 1 year nominal interest rate is 2% in US and 5% in UK. Should you hold U.K. bonds or U.S. bonds?

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Answer
Should

you hold U.K. bonds or U.S. bonds?

It depends on whether you expect the pound to depreciate vis--vis the dollar over the coming year. If you expect the pound to depreciate by more then 3.0%, then investing in U.K. bonds is less attractive than investing in U.S. bonds. If you expect the pound to depreciate by less than 3.0% or even to appreciate, then the reverse holds, and U.K. bonds are more attractive than U.K. bonds.

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Conclusion and a Look Ahead

We

have set the stage for the study of an open economy:

The choice between domestic goods and foreign goods depends primarily on the real exchange rate. The choice between domestic assets and foreign assets depends primarily on their relative rates of return, which depend on domestic interest rates and foreign interest rates, and on the expected depreciation of the domestic currency.

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Macroeconomics
Session 3: Macroeconomic Policies in an open economy

Types of exchange rate

In the context of an open economy the exchange rate system is very important.

Floating/Flexible Exchange Rate system - In a system of floating exchange rates, E is set by market forces of demand and supply and is allowed to fluctuate in response to changing economic conditions. In other words, the exchange rate E adjusts to achieve simultaneous equilibrium in the goods market and money market.
Fixed exchange rate system - Under fixed exchange rates, the central bank of the country trades domestic for foreign currency at a predetermined price. Under a fixed exchange rate, the central bank announces a value for the exchange rate and stands ready to buy and sell the domestic currency to keep the exchange rate at its announced level.

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Floating vs. fixed exchange rates

Argument for floating rates:

allows monetary policy to be used to pursue other goals (stable growth, low inflation).

Arguments for fixed rates:

avoids uncertainty and volatility, making international transactions easier. disciplines monetary policy to prevent excessive money growth & hyperinflation.
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Fiscal policy under flexible vs fixed exchange rates

Under flexible rates, fiscal policy is ineffective at changing output.

GADYMdi

EX-MY

GADYMdi

Under fixed rates, fiscal policy is very effective at changing output.

Fixed exchange rate implies Eet+1= Et. This in turn implies r =r*. Hence i cannot rise due to Md. So RBI steps in increasing Ms & keeping i from rising & currency from appreciating. Thus Y is sustained 79

Monetary policy under flexible vs fixed exchange rates

Under flexible exchange rate, monetary policy is very effective at changing output. Under fixed rates, monetary policy cannot be used to affect output.
Ms/P i E X-MY

Ms/P i E
But Fixed exchange rate implies Eet+1= Et. This in turn implies i =i*. Hence i cannot fall or E cannot due to Ms/P. So RBI steps in to buy domestic currency which lowers the Ms/P with the result 80 that E doesnot & Y

Trade policy under flexible vs fixed exchange rates

Under flexible rates, import restrictions do not affect Y or X -M. Under fixed rates, import restrictions increase Y and X -M. But, these gains come at the expense of other countries: the policy merely shifts demand from foreign to domestic goods.
A restriction on imports reduces imports. Less demand for foreign exchange exchange rate appreciates reduces exports X M is unchanged & there is less trade & Y is unchanged
Restriction on imports reduces imports. Less demand for foreign exchange exchange rate appreciates To keep E from appreciating, the central bank must sell domestic currency in exchange for foreign currency. E does not appreciate and hence the restriction on import is sustained and exports remain same NXY
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Summary of policy effects

type of exchange rate regime: flexible impact on: Policy fiscal expansion monetary expansion Y 0 E NX Y E 0 0 NX 0 0 fixed

import restriction

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Note: E means depreciation & E means appreciation

Case Study

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CASE STUDY: The Mexican peso crisis

35

U.S. Cents per Mexican Peso

30

25

20

15

10 7/10/94

8/29/94

10/18/94

12/7/94

1/26/95

3/17/95

5/6/95
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CASE STUDY: The Mexican peso crisis

35

U.S. Cents per Mexican Peso

30

25

20

15

10 7/10/94

8/29/94

10/18/94

12/7/94

1/26/95

3/17/95

5/6/95
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Understanding the crisis

In the early 1990s, Mexico was an attractive place for foreign investment. During 1994, political developments caused an increase in Mexicos risk premium ( ): peasant uprising in Chiapas assassination of leading presidential candidate Another factor: The Federal Reserve raised U.S. interest rates several times during 1994 to prevent U.S. inflation. (r* > 0)

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Understanding the crisis

These events put downward pressure on the peso. Mexicos central bank had repeatedly promised foreign investors that it would not allow the pesos value to fall,

so it bought pesos and sold dollars to prop up the peso exchange rate. Doing this requires that Mexicos central bank have adequate reserves of dollars. Did it?
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Dollar reserves of Mexicos central bank

December 1993 $28 billion August 17, 1994 $17 billion December 1, 1994 $ 9 billion December 15, 1994 $ 7 billion

During 1994, Mexicos central bank hid the fact that its reserves were being depleted.
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 the disaster

Dec. 20: Mexico devalues the peso by 13%

(fixes e at 25 cents instead of 29 cents)

Investors are SHOCKED! they had no idea Mexico was running out of reserves. , investors dump their Mexican assets and pull their capital out of Mexico. Dec. 22: central banks reserves nearly gone. It abandons the fixed rate and lets e float. In a week, e falls another 30%.
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The rescue package

1995: U.S. & IMF set up $50b line of credit to provide loan guarantees to Mexicos govt. This helped restore confidence in Mexico, reduced the risk premium. After a hard recession in 1995, Mexico began a strong recovery from the crisis.

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CASE STUDY: The Southeast Asian crisis 1997-98

Problems in the banking system eroded international confidence in SE Asian economies. Risk premiums and interest rates rose. Stock prices fell as foreign investors sold assets and pulled their capital out. Falling stock prices reduced the value of collateral used for bank loans, increasing default rates, which exacerbated the crisis.

Capital outflows depressed exchange rates.

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Data on the SE Asian crisis

exchange rate stock market nominal GDP % change from % change from % change 7/97 to 1/98 7/97 to 1/98 1997-98

Indonesia
Japan Malaysia Singapore

-59.4%
-12.0% -36.4% -15.6%

-32.6%
-18.2% -43.8% -36.0%

-16.2%
-4.3% -6.8% -0.1%

S. Korea
Taiwan Thailand U.S.

-47.5%
-14.6% -48.3% n.a.

-21.9%
-19.7% -25.6% 2.7%

-7.3%
n.a. -1.2% 2.3%
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The Impossible Trinity

A nation cannot have free Free capital capital flows, independent flows monetary policy, and a fixed exchange rate Option 2 Option 1 simultaneously. (Hong Kong) (U.S.) A nation must choose one side of this triangle and Fixed Independent Option 3 give up the exchange monetary (China) opposite rate policy corner.
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CASE STUDY: The Chinese Currency Controversy

1995-2005: China fixed its exchange rate at 8.28 yuan per dollar, and restricted capital flows. Many observers believed that the yuan was significantly undervalued, as China was accumulating large dollar reserves. U.S. producers complained that Chinas cheap yuan gave Chinese producers an unfair advantage. President Bush asked China to let its currency float; Others in the U.S. wanted tariffs on Chinese goods.
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CASE STUDY: The Chinese Currency Controversy

If China lets the yuan float, it may indeed appreciate. However, if China also allows greater capital mobility, then Chinese citizens may start moving their savings abroad. Such capital outflows could cause the yuan to depreciate rather than appreciate.

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Balance of Payments
Chandrima Sikdar

What is BOP?

A nations BOP is a summary statement of all its economic transactions with the rest of the world during a given year. Each transaction is entered in the BOP as a credit or a debit. A credit transaction is one that leads to the receipt of a payment from foreigners while a debit transaction leads to a payment to foreigners.
The main components of BOP are Current account Capital account Official reserve account
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Current Account

This includes trade in goods and services and unilateral transfers The main categories of service transactions are travel and transportation, receipts and payments on foreign investments and military transactions. Unilateral transfers refer to gifts made by individuals and the government to foreigners & gifts received from foreigners The exports of goods & services & receipt of unilateral transfers are entered in the current account as credits (+) because they lead to receipt of payments from foreigners. On the other hand, import of goods & services & granting of unilateral transfers are entered as debits (-) because they lead to payments to foreigners

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Capital Account

This shows the change in the nations assets abroad & foreign assets in the nation It includes direct investments (such as the building of a foreign plant), the purchase or sale of foreign securities (stocks, bonds and treasury bills), and the change in the nations non bank and bank claims on and liabilities to foreigners during the year Increase in nations assets abroad & reduction in foreign assets in the nation (other than official reserve assets) are capital outflows or debits (-) because they lead to payment to foreigners. On the other hand, decrease in nations assets abroad & increase in foreign assets in the nation (other than official reserve assets) are capital inflows or credits (+) because they lead to receipts from foreigners 99

Official reserve account

Measures the change in a nations official reserve assets & the change in foreign official assets in the nation during the year Official reserve assets include the gold holdings of the nations monetary authorities, special drawing rights (SDRs), the nations reserve position in the IMF and the official foreign currency holdings of the nation An increase in the nations official reserve assets are debits (-) while an increase in foreign official assets in the nation are credits(+)

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Double Entry Bookkeeping

Each international economic transaction is entered either as a credit or as a debit in the nations balance of payments. But every time a credit or a debit transaction is entered, an offsetting debit or credit respectively of the same amount is also recorded in one of the three accounts. This double entry book keeping

The reason for this is that every transaction has two sides- we sell something and we receive payment for it & we buy something and we must pay for it.
Example: An Indian tourist in London spends Rs 50,000 for hotels & meals- india debits the service category of its current account 101 for Rs 50,000 and credits its capital account for Rs. 50,000.

Statistical Discrepancy

Theoretically double entry book- keeping should result in total credits being equal to total debits when all three accounts of the BOP are taken together. However, because of recording errors and omissions, this equality does not usually hold. Thus a special entry called statistical discrepancy is necessary to balance the nations BOP statement.

102

Disequilibrium in the BOP

In the accounting sense BOP always balances. But this trivial balance in the BOP of a country does not mean that the BOP is always in equilibrium. There can be disequilibrium i.e. a deficit or a surplus in the BOP of a country though the BOP always balances in the accounting or ex-post sense
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Understanding the disequilibrium in the BOP

To understand this we divide all the transactions recorded in the accounting balance into two major categoriesAutonomous transactions Accommodating transactions

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Autonomous transactions

These are those transactions which are undertaken for their own sake, normally in response to business considerations and incentives and sometimes in response to political considerations as well. These transactions take place independently of the balance of payments position of the reporting country. Examples: these include virtually all exports & imports of goods & services, unilateral transfers, direct investment or portfolio investment motivated by a desire to earn either a higher return or to find a safe refuge
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Accommodating transactions

These are those transactions that do not take place for their own sake, but because autonomous transactions are such as to leave a gap to be filled. These are those transactions that occur as a direct consequence of the BOP situations. Example: include the sale of gold or foreign currencies by central bank with a view to filling the gap between the receipts & payments of foreign exchange by the residents country and a loan received by the monetary authorities of the reporting country from foreign government with the purpose of filling the gap between the autonomous receipts and autonomous payments.
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Understanding the disequilibrium in the BOP contd..

When autonomous receipts and autonomous payments are equal accommodating transactions do not take place Thus whether there is equilibrium or disequilibrium in the BOP of the country we consider the autonomous transactions If autonomous receipts = autonomous payments, the BOP is in equilibrium; if total autonomous receipt > total autonomous payments, the BOP has a surplus; if total autonomous receipt < total autonomous payments, the BOP has a deficit
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Understanding the disequilibrium in the BOP contd..

By disequilibrium in the BOP of a country we mean imbalance between the autonomous international payments (demand for foreign exchange) and receipts (supply of foreign exchange. A disequilibrium in the BOP of a country appears either as a deficit or as a surplus

108

Correcting disequilibrium in the BOPprice-specie flow mechanism

According to classical theory, if there is a deficit in the BOP of a country, then there will be outflow of gold from the country This will result in a fall of money supply and general price level in the country This in turn will increase exports & reduce imports of the deficit country and thus the BOP disequilibrium is automatically corrected
Price-Specie-flow mechanism Gold inflows & outflows changes in the quantities of money changes in the price level
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Correcting disequilibrium in the BOPchanges in foreign exchange rate

Changes in foreign exchange rates can also correct disequilibrium in the BOP Foreign exchange rate is the price of one unit of foreign currency expressed in terms of units of home currency A change in foreign exchange rate refers to a change in the value of home currency in terms of the foreign currency Domestic prices in the trading countries remaining unchanged a fall in price of home currency in terms of foreign currency, referred to as depreciation implies that prices of countrys exports will fall in the foreign currency and prices of her imports will rise in home currency Under freely flexible exchange rate system, a deficit in a countrys BOP automatically leads to depreciation ie. results to lowers the price of its home currency in terms of foreign currency. This in turn eliminates the deficit in the BOP.
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Correcting disequilibrium in the BOPincome-adjustment mechanism

A deficit in the BOP of a country lowers the national income of the country Import function is given by M =M (Y) where 0< m<1 implying import is an increasing function of national income. So as Y falls M also falls. Similarly, in a country having BOP surplus, Y rises leading to a rise in its M and thereby a rise in the export of deficit country The increase in exports and the fall in imports of the deficit country removes its deficit.
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Deliberate policies to correct BOP disequilibrium

Both price-specie flow as well as income adjustment mechanism are automatic adjustment mechanisms They do not always take place smoothly or even if they take place they take time to operate So the government is often forced to take deliberate policies
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Types of deliberate policies to correct BOP disequilibrium

If the BOP deficit is of a temporary nature the remedies areCountry may borrow foreign exchange from a foreign country or from international monetary institutions like the IMF Country can also attract private capital from abroad by raising the rate of interest in the economy & offering tax concessions to foreign investors Country can also run down its foreign exchange reserves
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Types of deliberate policies to correct BOP disequilibrium

If the BOP disequilibrium is of a long term nature then the country should adopt some measures to increase exports and reduce imports Two important methods are Devaluation or depreciation Deflation Other measures that lead to import control and export promotion can also be adopted.

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Depreciation/Devaluation

This means a fall in the price of the home currency in terms of foreign currency. Now-a-days this term is generally replaced by the term devaluation Devaluation means a reduction in the official value of the home currency in terms of gold. This in turn lowers the price of home currency in terms of foreign currency leading to depreciation. This in turn leads to a fall in price of the countrys exports in foreign currency & as such increases the demand for the countrys exports in the foreign countries. At the same time countrys import prices in terms of home currency increases and lowers the volume of countries imports
Devaluation increases the countrys exports and lowers her imports & hence corrects her BOP position But how much is improved depends on the countrys elasticities of supply of and demand for her exports & imports

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Deflation

This is the policy of reducing the quantity of money in order to reduce the price level and the money income of the people M falls domestic prices fall exports increase & imports fall BOP position is improved Besides, M falls r Foreign capital is attracted BOP position is improved
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Other measures that correct the BOP position

These are the measures that lead to import control and export promotion For example: reduction of export duties, export subsidies, bilateral trade agreement, imposition of import duties, import quotas etc.

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