Page 216 - DECO201_MACRO_ECONOMICS_ENGLISH

Unit 12: Balance of Payments

2. Net capital inflows increased significantly driven by higher net inflows under FII Notes
investments, external assistance, short-term trade credits, ECBs and banking capital.
3. Although net capital inflows increased significantly, accretion to reserves during
April-December 2010 was marginally lower mainly due to widening of the current account
deficit over April-December 2009.

Task Compare the BOP of India and China for 2009-2010.

Self Assessment

State whether the following statements are true or false:

11. India’s BOP was worst during 1970s.
12. Despite improvement in net invisibles surplus, the current account deficit widened during
April-December 2010.

13. Late 1980s and early 1990s was the best period for India’s BOP.

12.4 Automatic Adjustment in BOP

BOP is in disequilibrium or deficit if imports (M) are greater than exports (X). The monetary and
price effect approach is: when M > X, precious metals like gold and foreign exchange will
disappear from the domestic economy. Thus, money supply will reduce. This will lead to a
decline in the price level, more exports and less imports, thus correcting BOP deficit.

Monetary and price effects of BOP disequilibrium can also be expected to work under modern
conditions. When a country’s BOP is in deficit, surplus country will have to be paid in terms of
foreign exchange which will be purchased by taking out domestic currency from banks. This
will reduce bank deposits, thus decrease money supply, increase rate of interest which will
reduce investment and then income, employment output and finally price level. The higher rate
of interest will increase capital inflow which will reduce BOP deficit. Lower price now will
boost exports and reduce imports, helping again to correct BOP deficit on disequilibrium.

However, the price effect of BOP is intermingled with income effect (Keynesian Income Effect).
This can be understood from the analysis of foreign trade multiplier in the unit 7.
A flexible exchange rate has been adopted since 1971. In this system, the price of foreign currencies
varies according to their market demand and supply position. The demand for foreign currencies
is made by importers and investors and supply by exporters and immigrants. If people have to
spend more local currency for getting foreign currency, its demand will increase and vice versa.
Thus, the demand curve for foreign currency will have a negative slope and supply curve a
positive slope.
The adjustment mechanism under this system will function through changes in relative prices of
foreign exchange and finally in the relative prices of imports and exports. If demand is greater
than supply (in BOP deficit), the exchange rate will rise. This will mean rising price of imports
and fall in price of exports. These changes will ultimately bring about an equilibrium in demand
and supply of foreign exchange and thus in BOP.
Equilibrium of BOP is attained at OR exchange rate (Figure 12.1). If the income of the country
rises, import demand will rise and so also the demand for foreign exchange curve. Thus, the
price of foreign exchange goes up to OR1 where equilibrium is brought about by exchange
depreciation. So imports would be dearer and exports cheaper.

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