Balance of Payments

1. What is the Balance of Payments (BOP)?

Definition: BOP is the summary record of all economic transactions that take place in a country over a given period of time.

It records only two things → inflows and outflows, and BOP is the difference between them.

Wording from the notes: receipts of money from abroad = credit (inflow), entered in the current account with a + sign; outflows of money = debit, entered with a − sign.

2. Balance of Trade (BOT) & its link with BOP

Aggregate Demand (AD) = total demand of the whole economy, made of 5 components:

Definition: Balance of Trade = X − M = the difference between export revenue and import expenditure. (Export → we earn revenue; import → we spend.)

Why together? Export / import talk (of goods or services) is BOT; but exports create inflows and imports create outflows — and that is BOP.

Two quick cases (law of demand only)

Inflation = rise in prices. These cases use only the law of demand; PED refines them later (§6).

3. The Three Accounts of the BOP

BOP is built from 3 accounts: current, capital, financial. The current account is the largest portion.

① Current account (4 components)

1. Trade in goods = visible trade (goods can be seen, measured, compared — phone, pencil, lamp).
2. Trade in services = invisible trade.
3. Net income (also called primary income — appears in MCQs!). Can be + or − (comes in or goes out), in 3 forms: wages, interest, dividends.
4. Net transfers (also called secondary income). Can be + or −, but with a condition: government-to-government and in the form of aid (gift).

Net income — the 3 forms

• Wages: student abroad sends 1000 home ⇒ our country records wages received +1000 (inflow, credit). A worker here sends money abroad ⇒ wages paid − (outflow, debit).
• Interest (what a bank pays you): Pakistani bank pays 20%, US bank 10% ⇒ foreigners save here ⇒ our bank pays interest ⇒ interest paid (−, debit). Reverse (US 20%, Pak 10%) ⇒ our people save abroad ⇒ interest received (+).
• Dividend = profit on shares (own Apple shares ⇒ Apple pays a dividend at year-end). Our residents own foreign shares ⇒ dividend received (+). Foreigners own shares in our listed companies ⇒ dividends paid (−).

Net transfers — aid, not loans

Country B gives us aid ⇒ inflow, + sign. We give or repay aid abroad ⇒ outflow, − sign. These are big government-to-government deals — no middlemen/agents.

② Capital account — fixed assets (machines)

“Capital” here means machines / fixed assets (capital-intensive) — NOT the accounting “capital employed” (money first invested in a business). All money from buying and selling assets goes here.

e.g. buy a machine from Japan (specialised in machines) ⇒ outflow (−); later scrap/sell it back to Japan ⇒ inflow (+).

③ Financial account — investment

All money related to investment, in 3 forms: shares, loans, debentures.

• We buy foreign shares ⇒ shares purchased (−) in financial a/c; at year-end the dividend ⇒ dividend received (+) in current a/c.
• Foreigners buy shares of our companies (Toyota, Lucky Cement…) ⇒ money comes in ⇒ shares received (+) in financial a/c; the company later pays dividends paid (−) in current a/c.
• We take an IMF loan ⇒ loan received (+) in financial a/c; year-end interest paid (−) in current a/c.

So “who owns shares” decides the direction, but the rule never changes: principal → financial; return → current.

How to record — quick table

4. BOP Policies — the Big Picture

The problem: the country’s BOP is negative — outflows > inflows, because imports are high and exports are low.

The aim of BOP policies: convert negative → positive ⇒ increase inflows, reduce outflows (more exports, fewer imports) so money comes in more and goes out less. The government must implement policies.

PED recap — the key to every policy (PED = price elasticity of demand)

5. Expenditure Switching ① — Tariff

Target of the policy: switch the expenditure of domestic residents from imported goods to domestically manufactured goods. Two tools: tariff and depreciation / devaluation.

Definition: a tariff is a tax on imported goods ⇒ imported good looks expensive (price ↑) ⇒ quantity of imports ↓ ⇒ import expenditure ↓.

By how much quantity and expenditure fall is decided by PED — so there are two possible stories:

Side effects

The tariff diagram (learn the steps!)

1. Draw 2 axes. y = price of imported good, x = quantity of imported good. Demand slopes down, supply slopes up.
2. Label them D_D = domestic demand and D_S = domestic supply. (Why “domestic” when it’s an imported good? Our local supplier buys the import and sells it to our local consumer.) Where D_D = D_S is the equilibrium.
3. Draw a horizontal curve = world supply at the world price. It is perfectly elastic because there are thousands of producers in the world — a single producer cannot influence the price.
4. At the world price, Q_D > Q_S ⇒ a shortage of domestic goods ⇒ fulfilled by importing. So the whole triangle = imports; volume of imports before tariff = Q_D − Q_S.
5. The government puts a tariff ⇒ draw a second horizontal line above = world supply + tariff (= world price + tariff). New Q_D1 and Q_S1 ⇒ volume of imports after tariff = Q_D1 − Q_S1 (smaller triangle).

Model answer paragraphs (12-mark style)

6. Expenditure Switching ② — Depreciation & Devaluation

Meaning: both mean exchange rate ↓ = value of the currency ↓ (falls).

The chain (then PED decides the size)

exchange rate ↓ ⇒ foreign resident finds our exported good cheaper ⇒ Q_x ↑, export revenue ↑ ⇒ inflows ↑ — but by how much? PED.

exchange rate ↓ ⇒ imported good dearer for us ⇒ Q_m ↓, import expenditure ↓ ⇒ outflows ↓ — by how much? PED.

The story now splits into short run (everything inelastic) and long run (everything elastic).

① Short run — demand for BOTH goods is INELASTIC

② Long run — demand for BOTH goods is ELASTIC

The 4 PED diagrams — price falls / rises, compare the rectangles

Dashed grey rectangle = P₀ × Q₀ (before); coloured rectangle = P₁ × Q₁ (after) — green = good for BOP, red = bad. Steep demand curve = inelastic; flatter curve = elastic.

Summary table — depreciation / devaluation

Side effects to mention

• Short run: imports are inelastic and their expenditure rises ⇒ imported inflation (as in tariff).
• Long run: people switch to domestic goods ⇒ consumption ↑ ⇒ AD ↑ ⇒ demand-pull inflation — but also a benefit: unemployment ↓.

7. Expenditure Reducing ① — Appreciation & Revaluation

Target: expenditure reducing policy (also called expenditure damping policy — same meaning) targets to reduce the expenditure of domestic residents on imported goods. Switching is hard (people with inelastic demand just keep buying); reducing aims at the spending itself.

Two tools: ① appreciation / revaluation   ② fiscal & monetary policy (a demand-side policy). (Sir did appreciation first because depreciation was fresh in your mind.)

The chain (PED decides how much)

exchange rate ↑ ⇒ foreign resident finds our exports expensive ⇒ Q_x ↓, export revenue changes — by how much? PED.

exchange rate ↑ ⇒ we find imports cheap ⇒ Q_m ↑, import expenditure changes — by how much? PED.

① Short run — demand for BOTH goods INELASTIC

② Long run — demand for BOTH goods ELASTIC

The 4 diagrams again (mirror image of depreciation)

Steep curve = inelastic, flatter curve = elastic. Imported-good and exported-good diagrams — compare the before / after rectangles.

8. Expenditure Reducing ② — Fiscal & Monetary Policy

Idea: the target is to reduce AD so that residents’ spending on imported goods falls. So the government uses contractionary policy — contractionary fiscal or contractionary monetary (not expansionary!).

A. Contractionary fiscal policy — 2 tools

Fiscal policy has two tools: taxation and government expenditure. Do: tax ↑, government expenditure ↓.

This consumption falls because income falls — so it falls for both goods: domestic AND imported.

AD curve slopes down, AS slopes up; equilibrium where they meet gives price level and real income. Contractionary policy → AD shifts leftward → new equilibrium with lower price level and lower real income.

The government’s 5 macroeconomic objectives — what happens?

① price stability ② full employment ③ economic growth ④ BOP stability ⑤ redistribution of income & wealth

B. Contractionary monetary policy

Monetary policy has 2 tools — money supply & interest rate, and exchange rate — but for the BOP issue we use only money supply & interest rate, NOT the exchange rate.

Relation: money supply and interest rate have a negative relation — always think about the interest rate. (Interest rate = the rate at which you save in a bank or borrow from it.) To reduce AD ⇒ interest rate ↑ ⇒ money supply ↓.

Money-market diagram: y = interest rate, x = quantity of money. Demand curve slopes down; money-supply curve is vertical. Where MS = MD is equilibrium. MS ↓ shifts it left (MS → MS₁) ⇒ new equilibrium ⇒ new interest rate ↑ and quantity of money ↓.

Same score as fiscal: BOP positive + price stability achieved, but full employment and economic growth suffer.

Model conclusion paragraphs

9. Quick Recap — Full Chapter Cheat-Sheet