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Unit 12 : Equilibrium and Disequilibrium in BOP

is heading towards prosperity because by having surpluses, it either increases her foreign credits or Notes
reduces her foreign debits.
There is no doubt that a study of country’s balance of payment reveals much information about its
economic position and development of the country. But when we are to see that a country is heading
towards financial bankruptcy or higher standard of living, we are to examine the balance of payments
of many years of that country.
A persistent deficit in the balance of payments on current account certainly leads to economic and
financial bankruptcy. A continued favorable balance on current account is also disadvantageous
because it creates difficulties for other countries. The credit country may utilize her surplus in
advancing short or long term loans to the debtor country. But if it gives no opportunity to the debtor
country to repay the loan by exporting more, then how can the loans he realized ?
The hard earned surplus of the credit country will then one day be turned into gifts and this may
create political difficulties for the creditor country. We have seen, thus that a country should neither
have unfavorable nor favorable balance of payment on current account in perpetuity. It must obtain
equilibrium in her balance of payments over a reasonable period of time. From this it may not be
concluded that a country should balance her account every year with every country with which it has
trade relations.
Balance of payments equilibrium occurs when induced balance of payments transactions---those
engineered by the government to influence the nominal exchange rate---are zero. This implies that
autonomous receipts from exports and the sale of securities abroad equal autonomous payments for
imports and the purchase of securities from foreign residents. Since changes in the stock of official
reserves of foreign exchange are the method used by the authorities to fix or otherwise manipulate
the exchange rate, balance of payments equilibrium requires that the stock of foreign exchange reserves
be constant.
Induced transactions are frequent when the exchange rate is fixed---only by chance will autonomous
receipts and payments balance. They can also occur when the exchange rate is flexible and the
authorities want to influence its movement. But we will concentrate primarily on the fixed exchange
rate case here.

A country may have favorable balance of payment with one country and unfavorable
with another but in the long run it must balance her account. The total liabilities and total
assets of all nations related to one currency block must balance over a reasonable period
of time.

The condition of asset equilibrium---the LM equation---can be presented as the equality of the demand
and supply of nominal money balances as follows :

 −
1. M = mm H = mm (R + Dsc) = P γ θ ( *r + ) τ + ε Y 

where Y is real income, P is the price level, r* is the real interest rate determined by conditions
in the rest of the world, τ is the expected rate of inflation, mm is the money multiplier, R is the
stock of official foreign exchange reserves, which can be thought of as the foreign source
component of the stock of base money and Dsc is the domestic source component of the stock of
base money H. The above equation can be manipulated to present the equilibrium stock of high
powered or base money as

 −
2. H = R + Dsc = (P / mm) γ θ ( *r + ) τ + ε Y 

which can be further rearranged to move the stock of foreign exchange reserves R to the left
side.

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