urplus disequilibrium is termed as 'favourable balance'.

Causes of Disequilibrium in Balance of Payment

1. Population Growth

Most countries experience an increase in the population and in some likeIndia and China the population is not only
large but increases at a faster rate. To meet their needs, imports become essential and the quantity of imports may
increase as population increases.

2. Development Programmes

Developing countries which have embarked upon planned development programmes require to import capital goods,
some raw materials which are not available at home and highly skilled and specialized manpower. Since
development is a continuous process, imports of these items continue for the long time landing these countries in a
balance of payment deficit.

3. Demonstration Effect

When the people in the less developed countries imitate the consumption pattern of the people in the developed
countries, their import will increase. Their export may remain constant or decline causing disequilibrium in the
balance of payments.

4. Natural Factors

Natural calamities such as the failure of rains or the coming floods may easily cause disequilibrium in the balance of
payments by adversely affecting agriculture and industrial production in the country. The exports may decline while
the imports may go up causing a discrepancy in the country's balance of payments.

5. Cyclical Fluctuations

Business fluctuations introduced by the operations of the trade cycles may also cause disequilibrium in the country's
balance of payments. For example, if there occurs a business recession in foreign countries, it may easily cause a fall
in the exports and exchange earning of the country concerned, resulting in a disequilibrium in the balance of
payments.

6. Inflation

An increase in income and price level owing to rapid economic developmentin developing countries, will increase
imports and reduce exports causing a deficit in balance of payments.

7. Poor Marketing Strategies

The superior marketing of the developed countries have increased their surplus. The poor marketing facilities of the
developing countries have pushed them into huge deficits.

8. Flight Of Capital

Due to speculative reasons, countries may lose foreign exchange or gold stocks People in developing countries may
also shift their capital to developed countries to safeguard against political uncertainties. These capital movements
adversely affect the balance of payments position.

9. Globalisation

Due to globalisation there has been more liberal and open atmosphere for international movement of goods, services
and capital. Competition has beer increased due to the globalisation of international economic relations. The
emerging new global economic order has brought in certain problems for some countries which have resulted in the
balance of payments disequilibrium.

BOP Disequilibrium
:
BOP Disequilibrium BOP statements are prepared on the principles of accounting
There is often a surplus or deficit in BOP This is called Disequilibrium in BOP
:

Autonomous and Induced Transactions Autonomous transactions are carried out on

their own with a view to consume more or make profit They take place on both
current and capital accounts Unrequited items like gifts, donation and aid are
autonomous transactions
Induced Transactions :
Induced Transactions Balancing transactions are in form of international borrowing
and lending They are made for making payments for deficits in Balance of Trade
Assessment of BOP :
Assessment of BOP Autonomous transactions only are taken into account BOP
disequilibrium is of either surplus nature or deficit nature Current account deficit =
Net capital inflow Current account deficit is the result of autonomous transaction Net
capital inflow is induced transaction
Capital account transactions :
Capital account transactions Autonomous transactions Official transactions The
decrease in official foreign exchange reserves gives the measure of BOP deficit BOP
deficit = decrease in official foreign exchange reserves = current account deficit + net
capital inflow
Causes and Kinds of BOP :
Causes and Kinds of BOP Inflation and Fundamental Disequilibrium Business cycle
and Cyclic Disequilibrium Structural Changes and Structural Disequilibrium Shortterm Disequilibrium Seasonal deficits caused by crop failure Rapid growth of
population in food-deficient countries Ambitious development plans Demonstration
effect of advanced countries on developing nations
:
Automatic Adjustment in BOP BOP Adjustment can be done in two ways Classical
Approach Policy Measures

:
BOP Adjustment Under Fixed Exchange Rate 0 Y0 Y1 Y2 Income Y Interest Rate i3
i2 i0 F E G LM0 LM1 LM2 BOP IS0 i(%)
:
BOP Disequilibrium(Surplus) and Automatic Adjustment Under Flexible Exchange
Rate 0 Y1 Y2 Income Y Interest Rate i2 i1 F E LM IS2 BOP2 BOP1 i(%) IS1
:
BOP Disequilibrium(Deficit) and Automatic Adjustment Under Flexible Exchange
Rate 0 Y1 Y2 Income Y Interest Rate i2 i1 F E IS1 BOP1 BOP2 i(%) IS2 LM BOP
Deficit
:
BOP adjustment by policy measures
:
BOP adjustment by policy measures Mundell -Fleming Model Why Mundell
Fleming model: Required market condition do not exist Economic cost is very high
Surplus countries unwilling to allow adjustment
:
What are policy measures? Expenditure changing policies: - Monetary policy - Fiscal
policy Expenditure switching policy: - Devaluation - Revaluation Monetary approach
:
Trade Deficit (C + I + G) Y C + I + G Monetary Policy Fiscal Policy Assumption
fixed Exchange Rate Expenditure Changing Policies

:
BOP Adjustment through Monetary Policy
:
BOP Adjustment through Fiscal Policy Y0 Y1 Y2 Income (Y) Interest Rate (r) LM r1
r2 r3 IS3 IS2 IS1 K J E3 EB EB E1 E2
:
BOP Adjustment through Mix Policy
:
Assignment Dilemmas in Policy Mix
:
Mundellian policy Assingment
:
Parameters are unknown and difficult to determine Determination of exact
combination is difficult Prediction may differ due to non-economic factors Capital
flow is accommodating not autonomous Conflict between nations Problems in
Mundellian policy Assignment
:
Exchange Depreciation Exchange Appreciation Expenditure Switching Policy
:
Pre-Devaluation Bc 1 = Ac 5 As Import = 350 (Y) x Bc 30 = Bc 10,500 As Export =
100 (X) x Bc 60 = Bc 6,000 Trade deficit = Bc 4,500 Expenditure Switching Policy

:
Post-Devaluation Bc 1 = Ac 7 As Import = 300 (Y) x Bc 25 = Bc 7,500 As Export =
150 (X) x Bc 45 = Bc 6,750 Trade deficit = Bc 750 Expenditure Switching Policy
:
Devaluation and Internal and External Balance
:
Marshall Lerner Condition: BOP deficit only if demand is elastic BOP deficit if
demand is perfectly inelastic No effect if sum of price-elasticity equals Effectiveness
of Devaluation
:
Empirical Evidence and J-curve effect
:
Monetary Approach to BOP
:
Monetary Approach to BOP It was developed by Robert Mundell in 1968 and 1971
and Harry Johnson in 1972. According to the modern monetary approach BOP
disequilibrium is a monetary phenomenon.
:
Monetary Approach to BOP Demand and the supply of money is transitory
phenomenon and is self correcting in the long run. BOP surplus results when there is
excess of demand of money over the supply of money and vice versa. BOP bottoms
up.

:
The Self Correcting mechanism 0 100 200 300 400 500 600 20 40 60 80 Ms m (DB)
Md E K J L M Surplus Deficit International Reserves (bn Rs.)
Indias BOP 2006 - 09 :
Indias BOP 2006 - 09
Indias BOP 2006 - 09 :
Indias BOP 2006 - 09
:

:
THANK YOU

Types of Disequilibrium in Country's Balance of Payment

Balance of Payment of the country is determined by a multiplicity of forces and the equilibrium in it is the resultant of
numerous inter-related elements.

The main types of disequilibrium in the balance of payment are as follows :-

1. Structural Disequilibrium

It takes place due to structural changes in the economy affecting demand and supply relations in commodity and
factor market. Structural disequilibrium in balance of payments persists for relatively longer periods; as it is not easy
to remove structural imbalance in the economy.
Some of the important causes of structural disequilibrium are as follows :1.

If the foreign demand for a country's products decline due to the discovery of cheaper substitutes abroad,
then the country's export will decline causing a deficit.

2.

If the supply position of a country is affected due factors like crop failure, shortage of raw-materials, strikes,
political instability, etc, then there would be the deficit in the balance of payments.

3.

A shift in demand due to the changes in tastes, fashions, income, etc, would increase or decrease the
demand for imported goods causing a disequilibrium in the balance of payments.

4.

Changes in the rate of international capital movements may also cause structural disequilibrium.

5.

A war also results in structural changes which may affect not only goods but also factor of production
causing a disequilibrium in balance of payments.

2. Cyclical Disequilibrium

When disequilibrium is caused due to the changes in trade cycles, it is termed as cyclical disequilibrium. It is possible
that different phases of trade cycles like depression, prosperity, boom, recession, etc, may disturb terms of trade and
cause disequilibrium in balance of payments.
For instance, during boom period, imports may increase considerably due to increase in demand for imported goods.
During recession and depression, imports may be reduced due to fall in demand on account of reduced income.
During recession exports may increase due to fall in price. During boom period, a country may face deficit in its BoP
position on account increase in imports. However, during recession its export may increase, and as such BoP
position may show surplus.
Also, the importing countries may face cyclical changes. For instance, there may be recession in the importing
countries, which in turn would reduce demand for imports. Therefore, the demand for exports will decline and the
exporting country may face a trade deficit, which in turn may affect BoP positions.

3. Technological Disequilibrium

Technological disequilibrium in balance of payments is caused by various technological changes involve inventions or
innovations of new goods or new technique of production. These technological changes affect the demand for factors
and goods.
A technological change will give comparative advantage to the innovating country leading to the increase in exports
or a decline in imports. This will create disequilibrium in the balance of payments.

4. Short run Disequilibrium

Disequilibrium caused on a temporary basis for a short period, say one year is called short run disequilibrium. Such
disequilibrium does not pose a serious threat as it can be overcome within a short run. Such an disequilibrium may be

caused due to international borrowing and lending. When a country goes for borrowing or lending it leads to short run
disequilibrium. Such disequilibrium is justified as they do not pose a serious threat.
Short run disequilibrium may also be caused when a country's imports exceeds exports in a particular year. Such
disequilibrium is not justified as it has the potentiality to develop in to a crisis in time. The crisis in India in 1990-91 is
nothing but the development of short run disequilibrium. If the short run disequilibrium is persistant & occurs
repeatedly; it may pave the way for long run disequilibrium.

5. Long run or Secular Disequilibrium

It prevails for a long period of time i.e. when the disequilibrium is persistent & long run oriented, it is called long run
disequilibrium The IMF terms such disequilibrium as "Fundamental Disequilibrium".
Long-run or fundamental disequilibrium refers to a persistent deficit or a surplus in the balance of payments of a
country. It is also known as secular disequilibrium.
When there is a continuous increase in the stock of gold and foreign exchange reserves. there is a persistent surplus
& vise-versa.
Permanent changes in the conditions of demand and supply of exports and imports cause fundamental
disequilibrium. A permanent deficit or surplus may make a country debtor or creditor causing a fundamental
disequilibrium.
A developing country in its initial stages may import large amount of capital & hence its imports would exceeds
exports. When this becomes chronic, there emerges a secular deficit in its balance of payments. Deep rooted
dynamic changes like capital formation, innovations. technological advancements, growth of population etc. also
contribute to fundamental disequilibrium.
When there is a series of short-run disequilibrium in a country's balance of payments, ultimately it would lead to
fundamental disequilibrium.

6. Monetary Disequilibrium

Monetary disequilibrium, takes place on account of inflation or deflation. Due to inflation. the prices of the products in
the domestic market rises, and therefore, export items will become expensive. Such a situation may affect the BoP
equilibrium. Inflation also results in to increase in money income with the people, which in turn may increase demand
for imported goods. As a result imports may turn Bop position in disequilibrium.

Explain how BOP disequilibrium is restored under

a. flexible exchange rates.
b. fixed exchange rates, after you define what a BOP disequilibrium means.

a:
Using trade barriers such as tariffs, quotas and custom duties or monetary tools such as exchange rate
depreciation/appreciation, devaluation/evaluation, deflation/inflation.
b:
Only using trade barriers such as tariffs, quotas and custom duties, because monetary policy in this case
is just reactive tool to maintain exchange rate (though formally it is possible to use monetary equilibrating
correction methods, but price level spread may arise, making bank to pay high costs for maintaining fixed
exch-rate).
BoP - balance of payments.
BoP - disequilibrium means that open economy has continuing severe unemployment/over-employment
(output/GDP etc.)
There are few sources of BoP disequilibrium's, external and internal.
Though some specific tools depend on model you are referring to - you haven't specified it, for instance
Keynesian models (IS-LM or Mundel-Flemming) may suggest some fiscal tools depending on size of
economy.

The Balance of Payments (BoP)

A system of accounts that measures transactions of goods, services, income and
financial assets between domestic residents, businesses and governments and
the rest of the world during a specific time period.
Current Account (CA) measures the flow of goods, services, investment income
and transfers / gifts between domestic residents, businesses and governments
and the rest of the world.

Private Capital/Financial Account (PFA) A tabulation of the flows of

financial assets between domestic private residents and foreign private
residents.
Official Settlements Balance (OSB) tabulates transactions of reserve assets
(gold, SDRs, foreign currency holdings and reserve position in the IMF) by
official government agencies. Used for intervention in the FOREX market to
influence the ER. 2
Balance of payments accounts
1 Exports of goods and services (+)
Merchandise, Services (travel, insurance, banking etc).
Income from assets held abroad: interest, dividends etc.
2 Imports of goods and services (-)
Merchandise, Services (travel, insurance, banking etc).
Foreign investors' income from assets in the reporting country: interest,
dividends etc.
3 Unilateral transfers ((-) = net outflow)
4 Current account (=1 +2 + 3)
5 Private assets abroad, net (increase = capital outflow (-))
Direct investment, Portfolio investment.
6 Private foreign assets in reporting country, net (increase = capital inflow (+))
Direct investment, Portfolio investment
7 Capital account (5 + 6)
8 Change in foreign exchange reserves (4 + 7, increase = (-)) 3
9 Statistical discrepancy (+ or -)
10 Allocation of special drawing rights (+)
At any point in time, the BoP must balance, i.e. the sum of debt and credit items
is zero.

CA + PFA + OSB = 0

or

CA = KA

(assuming PFA + OSB = KA)

Thus, a current account (CA) deficit is financed by a positive capital account

(KA), i.e. by capital inflow.
A net debtor nation is one whose stock of foreign financial assets held by
domestic residents is less than the stock of domestic financial assets held by
foreign residents.
CA + PFA = OSB
If the LHS is negative (positive) (implying that there is an excess supply of
domestic currency), then OSB will have to be positive (negative) the central
bank finances the deficit by selling FOREX.
Note that, quite confusingly, a reduction (increase) in FOREX reserves show-up
as a positive (negative) number in OSB. 4
Example: What is balance of payments disequilibrium? Can a country run a balance of
payments deficit indefinitely? Using a simple diagram, explain how balance of payments
disequilibria are self-correcting under flexible exchange rates? How can balance of payments
disequilibria be corrected under fixed exchange rates?
Answer: Balance of payment (BoP) disequilibrium means that the current account deficit
(surplus) is not exactly matched by capital account surplus (deficit) and thus the authorities
are loosing (accumulating) official settlements balances or international reserves.
No, a country can not run a BoP deficit indefinitely because eventually it will run out of
international reserves.
BoP adjustment under flexible exchange rates
E

/
D
Quantity of FOREX
The foreign exchange market is in initial equilibrium at point A where imports (giving rise to
demand for FOREX) are equal to exports (providing supply of FOREX). That is, the current
account is in balance so the there is no implied change in international reserves (represented
here by FOREX). Now, suppose that due to an exogenous shock, the demand for imports
increase. This will shift the demand curve to the right and the economy will settle at a new
equilibrium, point B. The current account will be in deficit (due to increased imports). If the
exchange rate is flexible, then it will depreciate (it is higher at point B than at A), current
account will improve and eventually will be in balance again. 5
BoP adjustment under fixed exchange rates
E
S
S
/
B
A

C
D

D
Quantity of FOREX
After an increase in imports, there will be pressure on the exchange rate to depreciate
(economy will tend to go to point B). But, if the exchange rate is to be kept fixed then the
monetary authority will intervene and will meet the increased demand for FOREX (due to an
increase in imports) by selling FOREX (international reserves). Thus, the supply curve will
shift down and the economy will reach equilibrium at point C.

Example: A current account surplus is not always a sign of health; a current account deficit
is not always a sign of weakness. Comment on this statement keeping in view the broad
balance of payments concept.
Answer: Basic balance of payments identities show that a countrys current account balance
must equal its net capital flows from abroad. A current account deficit means that a country is
experiencing net capital inflows form abroad or a capital account surplus, meaning that the
country is a net debtor. Being a net debtor (or creditor) is not necessarily good or bad.
Capital inflows may add to a nations capital stock and increase an average residents ability
to purchase goods and services in the future. 6
Money Accounting
An important aspect of the CA is that it indicates the rate at which the economy
in the aggregate is adding to its net external assets. In terms of BoP concepts,
CA surplus equals the increase in net OSB plus the rate of private capital
outflow.
CA = NFA

(1)

The BoP and the Monetary Base

Balance Sheet of the Central Bank
Assets

Liabilities

NFA
DC

where NFA stands for net foreign assets and DC stands for domestic credit.
Domestic
S
M is determined as:
M hH
S
=
where h is money multiplier. If assume h = 1 M = H .

Using the balance sheet identity:

NFA DC M
cb
=+
or

NFA DC M

cb
= + 7
or

NFA M DC

cb
=

(2)

Thus, using equation (1) and (2) we can see that to avoid a current account
deficit, DC creation has to be held in line with the growth in M.
2 points:
i) Can understand the BoP stabilization programs conducted by the IMF. To
make the program work, the IMF imposes domestic credit ceiling that will
ensure that the central bank does not distort the CA targets by excessive
financing of government deficits or by loans to the domestic banking system.
ii) If the central bank intervenes in the FOREX market by buying or selling
FOREX (to keep ER fixed), there will be a change in the NFA position and a
corresponding change in M. Thus, FOREX changes automatically change the
stock of M (and an automatic adjustment process for the external balance). In
deficit countries the
S
M will be contracting, while in surplus countries it expands.
The CA, Credit Creation and Deficit Finance
First, we write the consolidated banking systems (commercial banks and
central bank combined) identity:
NFA M DC

b
=

(3) 8

Can write DC as:

g nb
DC = DC + DC

(4)

where
g
DC is credit to government and
nb
DC is credit to non-bank public.
Assuming that the governments budget deficit is financed by government
borrowing form the banking system or abroad, we have
gg
G T = DC NFA

(5)

Using (3), (4), (5)

()()
b nb g
NFA = M DC + T G NFA
Decrease in the banking systems net external asset position have as their
counterpart either an increase in credit to the public in excess of a rise in money
or a budget deficit that is financed by the domestic banking system.

DISEQUILIBRIUM IN BALANCE OF PAYMENT

Disequilibrium in balance of payment
The balance of payment of a country is said to be in equilibrium when the demand for foreign exchange is
exactly equivalent to the supply of it . The balance of payment is in disequilibrium when there is either a
surplus or deficit in the balance of payments. When there is deficit in the balance of payments, the
demand for foreign exchange exceeds the demand for it.
A number of factors may cause disequilibrium in the balance of payments. These causes may be broadly
categorised into:
1. Economic factors ;
2. Political factors ;

3. Sociological factors.
1. Economic factors
i. Development Disequilibrium
Large scale development expenditures usually increase the purchasing power, aggregate demand and
prices, resulting in substantially large imports. The development disequilibrium is common in developing
countries, because the above factores, and large scale capital goods imports needed for carrying out the
various development programmes, give rise to a deficit in the balance of payments.
ii. Capital Disequilibrium
Cyclical fluctuations in general business activity are one of the prominent reasons for the balance of
payments disequilibrium. As Lawrance W. Towle points out, depression always brings about a drastic
shrinkage in world trade, while prosperity stimulates it. A country enjoying a boom all by itself ordinarily
experiences more rapid growth in its imports than its exports, while the opposite is true of other countries.
But production in the other countries will be activated as a result of the increase exports to the boom
country.
iii. Secular disequilibrium
Sometimes, the balance of payments disequilibrium persists for a long time because of certain secular
trends in the economy. For instance in a developed country, the disposal income is generally very high
and, therefore, the aggregate demand, too, is very high. At the same time, production costs are very high
because of the higher wages. This naturally results in higher prices. These two factors-high domestic
prices may result in the imports being much higher than the exports. This could be one of the reasons for
the persistent balance of payments deficits of the USA.
iv. Structural disequilibrium
Structural changes in the economy may also cause balance of payments disequilibrium. Such structural
changes include the development of alternative sources of supply, the development of better substitutes,
the exhaustion of productive resources, the changes in transport routes and costs, etc.
2. Political Factors
Certain political factors may also produce a balance of payment disequilibrium. For, instance a country
plagued with political instability may experience large capital outflows, inadequacy of domestic investment
and production, etc. These factors may sometimes, cause disequilibrium in the balance of payments.
Further factors like wars, changes in world trade routes, etc. may also produce balance of payments
difficulties.
3. Social Factors
Certain social factors may also produce a balance of payments. For instance, changes in tastes,
preferences, fashion, etc. may affect imports and exports and thereby affect the balance of payments.
Correction of disequilibrium
A country may not bother about surplus in the balance of payment; but every country strives to remove or
at least to reduce, a balance of payment deflects. A number of measures are available to correcting the
disequilibrium. Some of them as follows
1. Automatic corrections
The balance of payment may be automatically corrected under the paper currency standard. The theory
of automatic correction is that if market forces of demand & supply are allowed to have free play the
equilibrium will automatically be restored in course of time.