It is important to note as to how a deficit or surplus in balance of payments is balanced. Let us take an example of two young men who both earn Rs. 10,000 per month. The first one spends Rs. 8,000 per month and saves Rs. 2,000 per month. The second one spends Rs. 12,000 and withdraws from his bank balance to meet his expenses. The accounts of both are balanced but the position of the first one is sounder. So also the necessary balance in a countryâ€™s balance of payments may be achieved under an extremely wide variety of circumstances and it matters a great deal what these circumstances are. The balanced international account may reflect stable conditions of equilibrium or it may reflect shocking conditions of instability. In the case of a young and relatively underdeveloped country, which has widely distributed investments, the balance of payments can show the extent to which its citizens are living on their past profits or it may be used to reveal how some countries live on tourism, shipping services and so on.
Changes in the underlying conditions which determine the flow of a countryâ€™s exports, imports, services or foreign investments will, of course, affect the composition of its balance of payments. The balance will be preserved but the altered composition of accounts may be adverse to the country or favorable. For example, a temporary disturbance like a bad domestic harvest will require the import of additional foodstuffs to supplement inadequate food supplies. Payment on current transactions will consequently suddenly increase and if they were previously equal to current receipts they now exceed them. The country is said to have deficit in its balance of payments because it is forced to draw upon its international reserves. Had the disturbance arisen from increasing popularity abroad of its exports or from the reduction of tariffs in the importing countries, its current receipts might have exceeded current payments. There would have been a surplus in its balance of payments causing its international reserves to rise.
Whether a disturbance in a countryâ€™s balance of payments, which causes a surplus or deficit, is favorable or unfavorable depends upon circumstances. Favorableness or un-favorableness is a relative matter. Therefore, it is better not to use the terms favorable or unfavorable when referring to balance of payments but to use instead more neutral terms such as deficit or surplus.
A nationâ€™s balance of payments is said to be in equilibrium when it is neither drawing upon its international reserves to make excess payments nor accumulating such reserves as a result of its receipts. The disturbances in balance of payment may be either short term to long term. Long term disturbances effect a lasting alteration in relations of one nationâ€™s economy to other nationsâ€™ economy. They result from changes in the forces which govern the kinds or amounts of a countryâ€™s exports and its imports, its position as a long term debtor or creditor or the character of the international services it renders. Each such disturbance upsets the pre-existing stability in the balance of payments and sets in motion a number of consequences which bring it to a stable position again.
Adjustment of Balance of Payments under the Gold Standard
A short term deficit can be met by any one or more of the following:
1. A decline in foreign balances
2. Export of gold,
3. Sale of domestically held securities in an international market, and
4. Short-term borrowings.
The first three sources are called international reserves. When the disturbances are purely temporary, they can met by drawing upon the countryâ€™s international reserves, or by borrowing.
If the deficit continues, a nation cannot go on indefinitely drawing upon its international reserves. After a relatively brief period, the countryâ€™s foreign balances will fall to an irreducible minimum. Its gold reserves will approach exhaustion and the foreigners will not be willing to extend any further loans. As a result, the following consequences may take place.
The initial contraction of money supply induced by the loss of gold and the necessity of protecting the countryâ€™s reserves affect the major items in the balance of payments. The demand for goods is reduced by the decline in the business activity; price fall; exports are stimulated; imports become less attractive; and gradually the rise in exports and the decline in imports rectifies the adverse balance of payments and a new equilibrium is reached. With a surplus in balance of payments, the opposite mechanism would be set in motion. These consequences may be summarized as follows:
Short term adjustment: (1) Reduced foreign balances, (2) Loss of gold, (3) Higher interest rates, (4) Short term borrowings.
Log term adjustment; (1) High interest rates (a) Decline in business activity, (b) Reduction in incomes. (2) Fall in prices leading to: (a) Increase in exports, (b) Decline in imports (New equilibrium)
Short term adjustment: (1) Increase in foreign balances, (2) Inflow of Gold (3) Lower interest rates, (4) Short term lending.
Long term adjustment: (1) Lower interest rates: (a) Increase in business activity, (b) Increase in incomes. (2) Increase in incomes. (2) Increase in prices leading to: (a) Decline in exports, (b) Increase in imports (New equilibrium).