Get the answer of: Is Balance of Payments Always in Equilibrium?
Balance of payments always balances means that the algebraic sum of the net credit and debit balances of current account, capital account and official settlements account must equal zero.
Balance of payments is written as:
B = Rf-Pf
where, B represents balance of payments,
Rf receipts from foreigners,
Pf payments made to foreigners.
When B = Rf– Pf = 0, the balance of payments is in equilibrium.
When Rf– Pf> 0, it implies receipts from foreigners exceed payments made to foreigners and there is surplus in the balance of payments. On the other hand, when Rf Pf < 0 or Rf < Pf there is deficit in the balance of payments as the payments made to foreigners exceed receipts from foreigners.
If net foreign lending and investment abroad are taken, a flexible exchange rate creates an excess of exports over imports. The domestic currency depreciates in terms of other currencies. The exports become cheaper relatively to imports. It can be shown in equation form:
X + B = M + If
Where X represents exports, M imports, If foreign investment, B foreign borrowing or X-M = I-B or (X-M)-(If-B) = 0
The equation shows the balance of payments in equilibrium. Any positive balance in its current account is exactly offset by negative balance on its capital account and vice versa. In the accounting sense, the balance of payments always balances. This can be shown with the help of the following equation:
C + S + T = C + I+G + (X-M)
or Y = C + 7 + G + (X- M) [Y = C + S + T]
where C represents consumption expenditure, S domestic saving, T tax receipts, I investment expenditures, G government expenditures, X exports of goods and services, and M imports of goods and services.
In the above equation.
C + S + T is GNI or national income (Y), and
C + l + G = A,
where A is called ‘absorption’.
In the accounting sense, total domestic expenditures (C + I + G) must equal current income (C + S + T) that is A = Y. Moreover, domestic saving (Sd) must equal domestic investment (Id). Similarly, an export surplus on current account (X > M) must be offset by an excess of domestic savings over investment (Sd. > Id ) . Thus the balance of payments always balances in the accounting sense, according to the basic principle of accounting.
In the accounting system, the inflow and outflow of a transaction are recorded on the credit and debit sides respectively. Therefore, credit and debit sides always balance. If there is a deficit in the current account, it is offset by a matching surplus in the capital account by borrowings from abroad or/ and withdrawing out of its gold and foreign exchange reserves, and vice versa. Thus, the balance of payments always balances in this sense also.