The Social Science Encyclopedia, Second Edition
A balance of payments is an accounting record of a country’s international transactions with the rest of the world. Foreign currency receipts from the sale of goods and services are called exports and appear as a credit item in what is termed the current account of the balance of payments. Foreign currency payments for purchases of goods and services are called imports and appear as a debit item in the current account. In addition, there are transactions in capital which appear in a separate capital account. Outflows of capital, to finance overseas investment, for example, are treated as debits, and inflows of capital are treated as credits. A deficit on current account may be offset or financed by a surplus on capital account and vice versa. Since the foreign exchange rate is the price of one currency in terms of another, total credits (the supply of foreign exchange) and debits (the demand for foreign exchange) must be equal if the exchange rate is allowed to fluctuate freely to balance the supply of and demand for foreign currency. If the exchange rate is not free to vary, however, deficits or surpluses of foreign currency will arise. Deficits may be financed by government borrowing from international banks and monetary institutions, such as the International Monetary Fund, or by selling gold and foreign currency reserves. Surpluses may be dissipated by accumulating reserves or lending overseas.
The fact that a flexible exchange rate guarantees a balance in the foreign exchange market does not mean that a country is immune from balance of payments difficulties. A country may experience a decline in real income and employment because of the inability of exports to pay for imports on current account. Such a deficit financed by capital inflows will not preserve jobs, nor will a depreciating currency necessarily guarantee that the current account deficit will be rectified.
Neither can a country be indifferent to the international value of its currency. Widely fluctuating exchange rates may adversely affect international trade. A rapidly depreciating currency, which raises the domestic price of imports, can be highly inflationary, which necessitates further depreciation, and so on.
In considering measures to adjust the balance of payments, therefore, it is highly desirable that countries should focus on the current account if they are concerned with the functioning of the real economy, and (if in deficit) wish to avoid turbulent exchange rates round a declining trend. Three major approaches to balance of payments adjustment have been developed by economists, corresponding to how deficits are viewed. First, the elasticities approach sees deficits as a result of distorted relative prices or uncompetitiveness in trade. Adjustment should work through exchange rate depreciation provided the sum of the price elasticities of demand for imports and exports exceeds unity. Second, the absorption approach views deficits as a result of excessive expenditure relative to domestic output, so that favourable adjustment must imply that expenditure falls relative to output. Third, the monetary approach ascribes deficits to an excess supply of money relative to demand, so that adjustment can be successful only if it raises the demand for money relative to the supply. In many contexts, particularly in developing countries, none of the approaches may be relevant where the problem is one of the characteristics of goods produced and exported, so that the price of balance of payments equilibrium is always slow growth. In this case, there is an argument for structural adjustment through planning and protection. If economic objectives are to be obtained simultaneously, a necessary condition is that the form of adjustment should be related to the initial cause of the disequilibrium.
A.P.Thirlwall
University of Kent
Further reading
Thirlwall, A.P. (1982) Balance of Payments Theory and the United Kingdom Experience, 2nd edn, London.
See also: international trade; Marshall-Lerner criterion.
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