Solutions to Assignments
IBO-01 International Business Environment
Solutions to Question No. 2 (A)
The main cause of the disequilibrium in the balance of payments arises from imbalance between exports and imports of goods and services. When for one reason or another exports of goods and services of a country are smaller than their imports, disequilibrium in the balance of payments is the likely result.
When the prices of goods are high in the country, its exports are discouraged and imports encouraged. If it is not matched by other items in the balance of payments, disequilibrium emerges.
- Cyclical Disequilibrium:
Cyclical disequilibrium is caused by the fluctuations in the economic activity or what are known as trade cycles. During the periods of prosperity, prices of goods fall and incomes of the people go down. These changes in incomes of the people and prices of goods affect exports and imports of goods and thereby influence the balance of payments.
“If prices rise in prosperity and decline in depression, a country with a price elasticity for imports greater than unity will experience a tendency for a decline in the value of imports in prosperity, while those for which imports price elasticity is less than one will experience a tendency for increase. These tendencies may be overshadowed by the effects of income changes, of course. Conversely, as prices decline in depression, the elastic demand will bring about an increase in imports, the inelastic demand a decrease.”
- Secular or Long-Run Disequilibrium:
Secular (long-run) disequilibrium in balance of payments occurs because of long-run and deep-seated changes in an economy as it develops from one stage of growth to another. The current account in the balance of payments follows a varying pattern from one stage to another.
In the initial stages of development, domestic investment exceeds domestic savings and imports exceed exports. Disequilibrium arises due to lack of sufficient funds available to finance the import surplus, or the import surplus is not covered by available capital from abroad.
Then comes a stage of growth when domestic savings tend to exceed domestic investment and export outrun imports. Disequilibrium may result because the long-term capital outflow falls short of the surplus savings or because surplus savings exceed the amount of investment opportunities abroad. At a still later stage of growth domestic savings tend to equal domestic investment and long-term capital movements are on balance, zero.
- Technological Disequilibrium:
Technological disequilibrium in the balance of payments is caused by various technological changes. Technological changes involve inventions or innovations of new goods or new techniques of production. These technological changes affect the demand for goods and productive factors which in turn influence the various items in the balance of payments. Each technological change implies a new comparative advantage to which a country adjusts to.
The innovation leads to increased exports if it is a new good and export-biased innovation. The innovation may lead to decline in imports if it is import-biased. This will create disequilibrium. A new equilibrium will require either increased imports or reduced exports.
- Structural Disequilibrium:
Let us see how the structural type of disequilibrium is caused. “Structural disequilibrium at the goods level occurs, when a change in demand or supply of exports alters a previously existing equilibrium, or when a change occurs in the basic circumstances under which income is earned or spent abroad, in both cases without the requisite parallel changes elsewhere in the economy.”
A change in supply may also cause a structural disequilibrium. Suppose Indian jute crop falls because of the change in the shift in the crop-pattern, Indian jute exports will fall and disequilibrium will be created. Apart from goods, a loss of service income may also upset the balance-of-payments position on current account.
Here we detail about the four methods adopted to correct disequilibrium in balance of payments.
1. Trade Policy Measures: Expanding Exports and Restraining Imports:
Trade policy measures to improve the balance of payments refer to the measures adopted to promote exports and reduce imports.
Exports may be encouraged by reducing or abolishing export duties and lowering the interest rate on credit used for financing exports. Exports are also encouraged by granting subsidies to manufacturers and exporters.
Therefore, India had to face great difficulties with regard to balance of payments. At several occasions it approached IMF to bail it out of the foreign exchange crisis that emerged as a result of huge deficits in the balance of payments. At long last, economic crisis caused by persistent deficits in balance of payments forced India to introduce structural reforms to achieve a long-lasting solution of balance of payments problem.
2. Expenditure-Reducing Policies:
The important way to reduce imports and thereby reduce deficit in balance of payments is to adopt monetary and fiscal policies that aim at reducing aggregate expenditure in the economy. The fall in aggregate expenditure or aggregate demand in the economy works to reduce imports and help in solving the balance of payments problem.
3. Expenditure – Switching Policies: Devaluation:
A significant method which is quite often used to correct fundamental disequilibrium in balance of payments is the use of expenditure-switching policies. Expenditure switching policies work through changes in relative prices. Prices of imports are increased by making domestically produced goods relatively cheaper. Expenditure switching policies may lower the prices of exports which will encourage exports of a country. In this way by changing relative prices, expenditure-switching policies help in correcting disequilibrium in balance of payments.
The important form of expenditure switching policy is the reduction in foreign exchange rate of the national currency, namely, devaluation. By devaluation we mean reducing the value or exchange rate of a national currency with respect to other foreign currencies. It should be remembered that devaluation is made when a country is under fixed exchange rate system and occasionally decides to lower the exchange rate of its currency to improve its balance of payments.
Under the Bretton Woods System adopted in 1946, fixed exchange rate system was adopted, but to correct fundamental disequilibrium in the balance of payments, the countries were allowed to make devaluation of their currencies with the permission of IMF. Now, Bretton Woods System has been abandoned and most of the countries of the world have floated their currencies and have thus adopted the system of flexible exchange rates as determined by market forces of demand for and supply of them.
4. Exchange Control:
We know that deflation is dangerous; devaluation has a temporary effect and may provoke others also to devalue. Devaluation also hits the prestige of a country. These methods are, therefore, avoided and instead foreign exchange is controlled by the government.
Under it, all the exporters are ordered to surrender their foreign exchange to the central bank of a country and it is then rationed out among the licensed importers. None else is allowed to import goods without a licence. The balance of payments is thus rectified by keeping the imports within limits.
After the Second War World a new international institution’ International Monetary Fund (IMF)’ was set up for maintaining equilibrium in the balance of payments of member countries for a short term. Member countries borrow from it for a short period to maintain equilibrium in the balance of payments. IMF also advises member countries how to correct fundamental disequilibrium in the balance of Payments when it does arise. It may, however, be mentioned here that no country now needs to be forced into deflation (and so depression) to root out the causes underlying disequilibrium as had to be done under the gold standard. On the contrary, the IMF provides a mechanism by which changes in the rates of foreign exchange can be made in an orderly fashion.
