(a) What is balance of payments? (b) List and explain six methods used in correcting an adverse balance of payment.

Answer Details

(a) What is balance of payments?

The balance of payments (BOP) is a systematic record of all economic and financial transactions between the residents of a country and the rest of the world over a given period, usually one year. It records receipts (inflows from exports and other credits) against payments (outflows for imports and other debits). It has three main parts: the current account (visible and invisible trade), the capital account and the official financing / monetary movements. A country has an adverse (unfavourable) balance of payments when its total payments to other countries exceed its total receipts.

(b) Six methods used in correcting an adverse balance of payments

1. Devaluation of the currency: Lowering the external value of the currency makes exports cheaper and imports dearer, so exports rise and imports fall, improving the balance.
2. Import restriction / quotas and tariffs: Placing quotas on, or raising import duties on, non-essential goods reduces the volume and value of imports.
3. Export promotion: Government encourages exports through subsidies, export incentives, and improved quality so as to earn more foreign exchange.
4. Exchange control: The government rations the foreign currency available for imports and other payments, thereby limiting outflows.
5. Deflationary (monetary and fiscal) policy: Raising interest rates and taxes and cutting government spending reduces domestic incomes and demand for imports, and attracts foreign capital.
6. Borrowing from abroad / drawing on reserves: The country may borrow from international bodies such as the IMF or use its external reserves to bridge the deficit temporarily.

(Other acceptable points: encouraging import substitution / local production; encouraging inflow of foreign investment and tourism.)