CHAPTER THREE

3. BALANCE OF PAYMENTS

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 3.1.National Income Accounting for Open
Economy
• The key macroeconomic difference between open
and closed economies is that, in an open economy, a
country‘s spending in any given year need not equal
its output of goods and services. A country can spend
more than it produces by borrowing from abroad, or
it can spend less than it produces and lend the
difference to foreigners.
• In an open economy gross domestic product (GDP)
differs from that of a closed economy because there
is an additional injection-export expenditure which
represents foreign expenditure on domestically
produced goods. 2
• There is also an additional leakage, expenditure on
imports which represents domestic expenditure on
foreign goods and which raises foreign national
income.
• The identity for an open economy is given by:
Y = C + I + G + X – M,
where Y is national income, C is domestic consumption, I
is domestic investment, G is government expenditure, X
is export expenditure and M is import expenditure.
• If we deduct taxation from the right-hand side of
equation, we have:-Yd = C + I + G + X – M –T, where
Yd is disposable income and if we denote private
savings as S = Yd– C we can rearrange equation to
obtain:
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(X – M) = (S – I) + (T – G)
Current account
balance
Net (dis)saving of
private sector

Government fiscal
deficit/surplus
• This equation says that a current account deficit has a
counterpart in either private dissaving that is private
investment exceeding private saving- and/or in a
government deficit- that, government expenditure
exceeding government taxation revenue.
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 Income determination in an open economy
• In an open economy, the equilibrium level of national income
is determined where the domestic balance is equals to the
external balance.
• The starting point would be the above equation:-
Y = C + I + G + X – M;
• And we would make certain additions to this equation.
Domestic consumption is partly autonomous and partly
determined by the level of national income. This is denoted
algebraically by: -
C =Ca + cY
where Ca is autonomous consumption and c is the marginal
propensity to consume, that is the fraction of any increase in
income that is spent on consumption.
• In this simple model consumption is assumed to be a linear
function of income. An increase in consumers' income induces
an increase in their consumption. 5
• Import expenditure is also assumed to be partly autonomous
and partly a positive function of the level of domestic income: -
M = Ma + mY,
where Ma is autonomous import expenditure and m is the
marginal propensity to import, that is the fraction of any increase
in income that is spent on imports.
• In this simple formulation import expenditure is assumed to be
a positive linear function of income.
• There are several justifications for this;
℗ On the one hand increased income leads to increased
expenditure on imports,
℗ And also more domestic production normally requires more
imports of intermediate goods. Government expenditure and
exports are assumed to be exogenous; government expenditure
being determined independently by political decisions, and
exports by foreign expenditure decisions and foreign income.
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By rearranging we obtain;
Y = Ca + cY + I + G + X – (Ma + My) =
Y – (Ca + cY + I + G) = X – (Ma + mY) =
Y – AD(Y) = NX(Y),
where AD is aggregate demand which is equals to Ca +
cY + I + G and NX is net export defined as X – (Ma + My).
• This equation tells us that the economy would be in
equilibrium where the domestic balance –i.e. Y – AD
is equals to the external balance – i.e. NX. Income
(Y) and net export balance associated with this
condition are the equilibrium levels of output and
trade balance.

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 3.2.Balance of Payments and terms of trade
(BoT)
Balance of payments (BoPs)
• The BoPs is one of the oldest and the most important statistical
statements for any country, especially the more open
economies.
• The Balance of Payments is a record (summary statement) of
the economic transactions between the residents of one
country and the residents of all other countries during a
particular period of time, usually a calendar year.
• BOP is recorded usually for a Calendar year. In other words
BOP is a systematic statistical statement or record of the
character and dimensions of the country‘s economic
relationship with the rest of the world.
• Balance of payments is integral parts of national accounts for
an open economy. 8
• The main purpose of the Balance of Payment is to inform the
Government of the international economic position of the nation
and to help in formulating its of monetary, fiscal and trade
policies.
• The Foreign Governments also use the Balance of Payment
accounts for the purpose of formulating trade relation with other
countries. Other economic agents like Bank firms and individual
may also depend upon the Balance of Payment accounts for
various purposes.
• The Balance of Payment account have significant role in an open
economy. An open economy is one which has economic relations
with the rest of the world.
• An economic transaction is an exchange of value, involving a
payment or receipts of money in exchange of a good, a service or
an asset for which payment is made between the resident of a
country with resident of the rest of the world.
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• An international economic transaction is systematically
recorded in the books of accounts of balance of
payments. Balance of payments are maintained in a
‗Double entry book keeping principle‘.
• Under such principle each transaction is the balance of
payments is entered as a Credit or a Debit entry. A ‗Credit
entry‘ in Balance of Payments refers to an inflow or that
transaction is the one that shows a receipt of funds from
the rest of the world. Similarly a ‗Debit entry‘ Balance of
Payments refers to an outflow or that transaction is the
one that shows a payment of funds to the rest of the
world.
• According to the Double entry book keeping principle, for
each Debit entry a corresponding Credit entry is made to
keep the balance of payment always in balance. 10
 Balance of Trade (BoT)
• Balance of trade is the difference between the values of
goods and services sold to foreigners by the residents and
firms of home country and the value of goods and services
purchased by them from foreigners.
• It can also be defined by the difference between the
values of goods and services exported and imported by a
country.
• If the two sums, that is the value of exports and imports
are equal to each other, it is called balance of trade
equilibrium. If the sum of exports exceeds that of the sum
of imports, the balance of trade is exhibiting surplus and
called favorable trade balance, if the sum of imports
exceeds that of the sum of exports, the balance of trade is
in deficit and called unfavorable trade balance 11
• The balance of trade is the official term for net exports
that makes up the balance of payments. The official
balance of trade is separated into the balance of
merchandise trade for tangible goods and the balance
of services.
• A balance of trade surplus is most favorable to
domestic producers responsible for the exports.
However, this is also likely to be unfavorable to
domestic consumers of the exports who pay higher
prices.
• Alternatively, a balance of trade deficit is most
unfavorable to domestic producers in competition with
the imports, but it can also be favorable to domestic
consumers of the exports who pay lower prices.
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 Balance of payment accounting principles
• The arrangement of international transactions in to a
balance of payments account requires that each
transaction be entered as a credit or a debit.
• The following transactions are transactions which are
debits from Ethiopian view point, which involve
payments to foreigners, include the following:
℗ Merchandise (goods and services) imports;
℗ Transportation and travel expenditures ;
℗ Income paid on investments of foreigners;
℗ Gifts to foreign residents!
℗ Aid given by the Ethiopian government!
℗ Overseas investment by Ethiopian residents.

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• And the following transactions are credits which
lead to the receipt of birr from foreigners from the
Ethiopian perspective.
® Merchandise (goods and services) exports;
® Transportation and travel receipts;
® Income received from investments abroad;
® Gifts received from foreign residents;
® Aid received from foreign governments;
® Investments in Ethiopia by overseas residents.

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 3.3.Components of balance of payments
• There are two basic elements in a perfectly compiled set of
balance of payments: the current account and the capital
account.
• In practice, there is a third element–the balancing item or errors
and omissions–which reflects our inability to record all
international transactions accurately
A. The Capital Account
• Capital transactions in the BoPs include all international
purchases or sales of assets. The term asset is broadly defined to
include items such as titles to real estate, corporation stocks and
bonds government securities, and ordinarily commercial bank
deposits.
• The capital account records all international transactions that
involve a resident of the country concerned changing either his
assets with or his liabilities to a resident of another country. 15
• The basic distinctions are between private and official,
between direct and portfolio investments, and by the
term of the investment (i.e., short term or long –
term).
• (i) Short Term Capital Bank deposits and other short –
term payments and receipts fall in to this category.
The vast majority of short term capital transactions
basically represent bank transfers that finance trade
on goods and services.
• (i) Long – Term Capital Long term capital includes the
amount of capital that has moved in to or out of the
country in a year. This includes: Government Loans to
Foreign Governments , Private Direct Investment and
Private Portfolio investment .
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 B. The Current Account
• The other component of BoPs is the current account
which records exports and imports of goods and services
and unilateral transfers.
• The current account of the balance of payments refers
to the overall accounting of the monetary value of
international flows associated with transactions in
goods, services and unilateral transfers.
• The goods and services component of the current
account shows the monetary value of all of the goods
and services a nation exports or imports.
• The goods account of the current account includes the
monetary value of merchandise exports and imports.
These items of foreign exchange earnings and spending
are called visible‘ items and hence form the visible17
trade balance in the BoPs.
• The services part of the current account records all the
services exported and imported by a country in a year.
Their net value is entered in the BoPs as invisible trade
balance.
• Services are called invisible in the sense that their
receipts and payments are not recorded at the port of
entry.
• The other component is unilateral transfers. It is also
called unrequited receipts, which the residents of a
country receive for free‘, without having to make any
present or future payments in return which includes all
gifts grants and reparation recipients and payments to
foreign countries.
• It consists of two parts which are government and
private transfer payments. 18
 C. The Remaining Items in the BoPs
• As we all know that most of the times the monetary values of
debited items and credited do not match. This may be because of a
number of reasons.
• The most important cause is the inability of government
statisticians to acquire all the necessary information in compiling
the BoPs.
• The cost of collecting balance of payments statistics is high, and a
perfectly accurate collection system would be prohibitively costly.
• Government statisticians thus base their figures partly on
information collected and partly on estimates. When statisticians
sum the credits and debits, it is not surprising when the two totals
are not equal. Because total debits must equal total credits in
principle, they insert a residual to make the totals equal.
• This correcting entry is known as errors and omissions or statistical
discrepancy.

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• In the BoPs statement, errors and omissions is treated
as part of the capital account because short term
capital transactions are generally the most frequent
source of error.
• Besides statistical and recording errors, the sub-
account of errors and omissions also includes
smuggling, illegal and secret capital movements and
imperfect estimation procedures

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 3.4.Balance of payment disequilibrium
(deficit and surplus in the BOP)
• Before we directly discuss about deficits and surpluses in BoPs, let
us make the following distinction between autonomous and
accommodating transactions. The distinction is useful to define
the concepts of deficit and surpluses in the BoPs.

Autonomous and Accommodating Transactions

• Autonomous transactions are the causes of balance of payments
situation, accommodating transactions are the results of the
balance of payments situations.
• Economists make a distinction between autonomous (above the
line items) and accommodating (below the line) items. The
former are transactions that takes place independently of the
balance of payments, while accommodating items are those
transactions which finance any difference between autonomous
receipts or payments 21
• All credit and debit entries in the current and capital accounts of
the BoPs are regarded as autonomous transactions.
• But, all the credit and debit entries in the changes in reserves
(international liquidity) account are to be taken as accommodating
transactions.
• The distinction between autonomous and accommodating
transactions therefore lies in the question whether the
transaction has caused the BoPs situation or has been caused by
the BoPs situation
• A surplus in BoPs results when the autonomous credit receipts
exceed the autonomous debit payments and a deficit in the BoPs
occurs when the autonomous payments (debits) exceed the value
of autonomous receipts (credits). If the two sums, autonomous
receipts and payments, are equal, we have equilibrium in the
BoPs.

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• Alternatively, the sum of accommodating transaction
entered as credit in the international liquidity account is
the measure of a deficit in the BoPs. While a similar
debit (negative) entry of that account is the measure of
a surplus in the BoPs.
• If, however, this account shows an entry of a zero sum,
then there would be equilibrium in the balance of
payments of the country under consideration.

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 Summary of key balance of payments concepts
1. Trade Balance = Exports of goods – Imports of goods
2. Current Account = Trade balance + Exports of services +
Interest, dividends and profits received + Unilateral
receipts – Imports of services – Interest, dividends and
profits paid – Unilateral payments abroad
3. Basic Balance = Current account balance + Balance on
long-term capital account
4. Official Settlements Balance = Current account balance
+ Balance on capital account + Statistical error 24
 3.5 Approaches to Balance of Payments
• In this section, we will examine the impact of exchange
rate adjustments on the balance of payments.
• The first - the elasticity approach emphasizes the relative
price effects of depreciation and suggests that
depreciation works best when demand elasticity‘s are high.
• The absorption approach deals with the income effects of
depreciation. The implication is that a decrease in
domestic expenditure relative to income must occur for
depreciation to promote payments equilibrium.
• The monetary approach stresses the effects depreciation
has on the purchasing power of money and the resulting
impact on domestic expenditure levels. Let us now see
each approach one by one.
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 1. The Elasticity Approach
• Currency devaluation (depreciation) affects a country‘s
balance of trade through changes in the relative prices
of goods and services internationally.
• A trade deficit nation may be able to reverse its
imbalance by lowering its relative prices, so that exports
increase and imports decrease.
• The nation can lower relative prices by permitting its
exchange rate to depreciate in a free market or formally
devaluing its currency under a system of fixed exchange
rates.
• The ultimate outcome of currency depreciation
(devaluation) depends on the price elasticity of demand
for a nation‘s imports and its exports.
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• Price elasticity of demand refers to the responsiveness
of buyers to changes in price. Mathematically: -
% Change in Quantity Demanded ΔQ /Q
Elasticity = =
% Change in Price Δ P/P
• Depending on the size of the demand elasticity‘s for
Ethiopian exports and imports, Ethiopia‘s trade balance
may improve, worsen or remain unchanged in response
to the birr devaluation. The general rule that
determines the actual out come is the so-called
Marshal- Lerner condition.
The Marshal Lerner condition states:
1. Devaluation (depreciation) will improve the trade
balance if the devaluing nation‘s demand elasticity for
imports plus the foreign demand elasticity for the nation‘s
exports exceeds 1. 27
2. If the sum of the demand elasticity‘s is less than 1,
devaluation will worsen the trade balance.
3. The trade balance will be neither helped nor hurt if the
sum of the demand elasticity‘s equals 1.
• The condition may be stated in terms of the currency
of either the nation undergoing devaluation or its
trading partner, but it cannot be expressed in terms of
both currencies simultaneously.
Two effects occur once a county’s currency devaluate and
these are,
1. The Price Effect
2. The Volume Effect

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i. The Price Effect: – This effect arises because export
become cheaper measured in foreign currency. For example
if coffee costs $ 1 USD when exchange rate was 10 birr
/USD, it costs only 0.5 when birr devaluate to 20/1, USD. On
the other hand import becomes more expensive after
devaluation. This price effect clearly contribute to a
worsening of the current account
iii. The Volume Effect: - This effect arises due to the fact
that when export becomes cheaper, more will be exported.
In other words cheaper export encourage an increased
volume of exports, and the effect that imports become
more expensive should lead to a decrease volume of
imports The volume effect clearly contributes to improving
the current account.
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• The net effect depends up on which effect dominates.
If the increases in export volume not sufficient to out
weight a decrease in price, then less will be received
from export in the foreign currency.
• Similarly, if the decrease in import volume is not
sufficient to out weight the increase in import price,
then more will be paid for imports in the domestic
currency. The result is that current account moves from
balance to deficit
The possibility that devaluation may lead to a worsening
rather than improvement the balance of payment led to
many researchers to find empirical evidence of the
elasticity of demand for export and imports.

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The possibilities that in the short-run the Marshall -
Lerner conditions may not be fulfilled though it may hold
in the long-run leads to a phenomenon called J-curve
effect.
J-Curve Effect:- According to this effect in the short run
export volumes and import volume, do not change much,
as a result the price effect out weight the volume effect
and this lead to a deterioration in the current account
balance.
• However, after a time lag export volume start to
increase and import volume start to decline. This leads
to gradual improvement of current account balance
and eventually moves to surplus.

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• There are different explanation as to the low
responsiveness, of export and import volume in the
short-run and why the response is greater in the long-
run.
1. A time lag in the consumer’s response: - It takes time
for consumers in both the devaluating country and the
rest of the world to respond to the changed competitive
situation.
2. A time lag in producer, response: - Even if devaluation
improves the competitive position of exports, it will take
time for domestic producers to expand production of
exportable goods.
3. Imperfect Competition: - penetrating the foreign market
and building market share in the foreign market is not an
easy operation and is a time –consuming and costly
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business
 2. The Absorption Approach
• According to the elasticity‘s approach, currency
devaluation offers a price incentive to reduce imports
and increase exports.
• But even if elasticity conditions are favorable, whether
the home country‘s trade balance will actually improve
may depend on how the economy reacts to the
devaluation.
• The absorption approach provides insights into this
question by considering the impact of devaluation on
the spending behavior of the domestic economy and the
influence of domestic spending on the trade balance.

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• The absorption approach starts with the idea that the
value of total domestic output (Y) equals the level of
total spending. Total spending consists of consumption
(C), investment (I), government expenditure (G) and
net exports (X-M. That is:-Y = C+I +G+ (X-M).
• The absorption approach then consolidates C+I+G in to
a single term A, which is referred to as absorption. (X-
M) is designated as B.
• Total domestic output thus equals the sum of
absorption and the level of net exports, or Y= A + B = B
= Y – A.
• This expression suggests that the balance of trade (B)
equals the difference between total domestic output
(Y) and the level of absorption (A).
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• If national output exceeds domestic absorption, the
economy‘s trade balance will be positive. Conversely, a
negative trade balance suggests than an economy in
spending beyond its ability to produce.
• The absorption approach predicts that, if currency
devaluation is to improve an economy‘s trade balance,
national output must rise relative to absorption.
• This means that a country must increase its total
output, reduce its absorption, or do some
combination of the two.

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 3. The Monetary Approach
• According the monetary approach, currency
devaluation may induce a temporary improvement in a
nations BOPs position.
• Assume, for instance, that equilibrium initially exists in
the home country‘s money market. A devaluation of the
home currency would increase the price level (that is ,
the domestic currency prices of potential imports and
exports).
• This increases the demand for money because larger
amounts of money are needed for transaction. If that
increased demand is not fulfilled from domestic
sources, an inflow results in a BOPs surplus and a rise in
international reserves.
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• But the surplus doesn‘t last forever. By adding to the
international component of the home – country
money supply, the devaluation leads to an increase in
spending (absorption), which reduces the surplus.

• The surplus eventually disappears when equilibrium is

restored in the home country‘s money market.
• The effects of devaluation on real economic variables
are thus temporary.
• Over the long run, currency devaluation merely raises
the domestic price level.

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