Fiscal policies to correct disequilibrium in bop

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Cosmopolitan’s Valia CL College of Commerce, BSc. (IT) & BMS.

D.N.Nagar, Andheri (w), Mumbai-400053.

A PROJECT

ON

“Fiscal Policy to Correct Disequilibrium in BOP”

In the subject of Economics of Global Trade and Finance

SUBMITTED TO

UNIVERSITY OF MUMBAI,

FOR SEMESTER-2 OF

MASTER OF COMMERCE

By

Avinash Vilas Chavan

Roll No. 04

UNDER THE GUIDANCE OF

Prof. Jose Augustine

YEAR: 2014-2015

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Cosmopolitan’s

Valia CL College of Commerce, BSc. (IT) & BMS.

D.N.Nagar, Andheri (w), Mumbai-400053.

DECLARATION BY THE STUDENT

I, Avinash Vilas Chavan

Roll No. 04 hereby declare that the project for the paper

Economics of Global Trade and Finance, titled

“Fiscal Policy To Correct Disequilibrium In BOP”

Submitted by me for semester-2 during the academic year 2014-2015, is based on

actual work carried out by me under the guidance and supervision of

Prof. Jose Augustine.

I, further state that this work is original and not submitted anywhere else for any

examination.

Signature of Student

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EVALUATION CERTIFICATE

This is to certify that the under signed have assessed and

evaluated the project on “Fiscal Policy To Correct

Disequilibrium In BOP”

Submitted by Avinash Vilas Chavan Student of M.Com. Part-I

(Semester-II).

This project is original to the best of our knowledge and has

been accepted for Internal Assessment.

Internal Examiner External Examiner Principal

(Prof. Jose Augustine) (Prof. ) (Dr. Satheesh menon)

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Acknowledgement

To list who all helped me is difficult because they are so

numerous and depth is so enormous.

I would like to acknowledge the following as being idealistic channel and fresh dimension in the completion of this project.

I take this opportunity to thank the University of Mumbai for giving me chance to do this project.

I would like to thank my Principal Dr. Satheesh menon, for

providing the necessary facilities required for completion of this project.

I take this opportunity to thank our co-ordinator Prof. V.M.Mathew, for his moral support and guidance.

I would also like to express my sincere gratitude towards my

project guide Prof. Jose Augustine under whose guidance and care made the project successful.

I would like to thank my college library, for having provided various reference books and magazines related to my project.

Lastly, I would like to thank each and every person who directly

or indirectly helped me in the completion of the project, especially my parents and my peers who supported me

throughout my project.

(Avinash V. Chavan)

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Cosmopolitan’s Valia CL College of Commerce, BSc. (IT) & BMS.

D.N.Nagar, Andheri (w), Mumbai-400053.

Internal Assessment: Protect 40 marks

Name of the Student: Chavan Avinash Vilas

Class: M.Com. Part-I Semester-II Roll Number: 04

Subject: Economics of Global Trade and Finance

Topic for the project: Fiscal Policy To Correct Disequilibrium In BOP

Marks

Awarded

Signature

Documentation

Internal Examiner

(Out of 10 Marks)

External Examiner

(Out of 10 Marks)

Presentation

(Out of 10 Marks)

Viva and Interaction

(Out of 10 Marks)

Total Marks(out of

40)

College Stamp

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INDEX

S.R.

NO.

PARTICULAR

1. Balance Of Payments

2. India’s Balance Of Trade

3. Reasons For Poor Performance Of India’s Export Trade

4. Equilibrium And Disequilibrium In BOP

5. Types Of Disequilibrium In BOP

6. Causes OF Disequilibrium In BOP

7. Measures To Correct Disequilibrium In BOP

Fiscal Policy And its Meaning

Objective OF fiscal Policy

8. Roles OF Fiscal Policy To Correct Disequilibrium

9. BIBILOGRAPHY

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FISCAL POLICIES TO CORRECT DISEQUILIBRIUM IN BOP

BALANCE OF PAYMENTS:-

The Balance of payment (BOP) of a country is a systematic account of all economic Transaction

between a country and the rest of the world, undertaken during a specific period of time. BOP is

the difference between all receipts from foreign countries and all payments to foreign countries.

If the receipts exceeds payments, then a country is said to have favourable BOP, and vice versa.

According to Charles Kindle Berger “The BOP of a country is a systematic recording of all

economic transaction between residents of that country and the rest of the world during a given

period of time.”

The Balance of payments record is maintain in a standard double- entry book- keeping method.

International transactions enter into records as credit or debit. The payments received from

foreign countries enter as Credit and payments made to other countries as debit. The following

table shows the elements of BOP.

BALANCE OF PAYMENTS ACCOUNT

Receipts (credit) Payments (Debit)

1. Export of Goods Imports of Goods

Trade Account Balance

2. Export of Services

3. Interest profit and dividends received

4. Unilateral Receipts

Imports of services

Interest, profits and dividend paid

Unilateral payments

Current Account Balance

5. Foreign Investment

6. Short term Borrowings

7. Medium and long term Borrowing

Investments abroad

Short term lending

Medium and long term lending

Capital Account Balance

8. Errors and omissions

9. Change in reserves(+)

Errors and omissions

Change in reserves(-)

Total Receipts = Total Payments

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1. Trade balance

Trade balance is the difference between export and import of Goods, usually referred

as visible or tangible items. If the exports are more than imports, there will be trade

surplus and if imports are more than exports, there will be trade deficit. Developing

countries have most of the time suffered a deficit in their balance of payments. The trade

balance forms a part of current account. In 2008-09 trade of India was 118.6 US $ billion.

2. Current account balance:

It is the difference between the receipts and payments on account of current account

which includes trade balance. The current account includes export of services, interest,

profits, dividends and unilateral receipts from abroad and the imports of services, profits,

interest, dividends and unilateral payments abroad. There can be either surplus or deficit

in current account. When debits are more than credit or when payments are more than

receipts deficit take place. Current account surplus will take place when credit are more

and debit are less.

Current account balance is very significant. It shows a country’s earning and payments

in foreign exchange. A surplus balance strengthens the country’s international financial

positions. It could be used for development of country. A deficit is a problem for any

country but it creates a serious for developing countries. In 2009-10 India’s current

account deficit was 38.4 US $ billion.

3. Capital account balance:

It is difference between receipts and payments on account of capital account. The

transaction under this title involves inflow and outflow relating to investments, short

terms borrowing lending, and medium term to long term borrowing/ lending. There can

be surplus or deficit in capital account. When credit are more than debits surplus will take

place and when debits are more than credits deficits will take place. In 2009-10 India’s

capital account surplus was 51.8 US $ billion.

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4. Errors and omission:

The double entry book-keeping principal states that for every credits, there is a

corresponding debit and therefore, there should be balance in BOP as well. In reality Bop

may not balance, due to errors and omission. Errors may be due to statistical

discrepancies (differences) and omission may be due to certain transaction may not get

recorded. For e.g. remittance by an Indian working abroad to India may not get recorded

etc. if the current and capital account shows a surplus of 20000 $, then the BOP should

show an increase of 20000 $. But if the statement shows an increase of 22000 4, then

there is an errors or omission of 2000 $ on credit side.

5. Foreign exchange reserve:

The balance of foreign exchange reserve is the combined effects of current and capital

account balance. The reserve will increase when:-

a). The surplus capital account is much more than the deficit in current account.

b). The surplus in current account is much more than deficit in capital account.

c). Both in current account and capital account shows a surplus.

In 2009-10 India’s foreign exchange reserve increased by 13.4 US $ billion.

INDIA’S BALANCE OF TRADE:

Balance of trade is the difference between exports and imports. India’s Balance of Trade is

mostly in deficit. This is due to low share off exports in world market. Imports are high due

to petroleum, oil and lubricant product.

INDIA’S BALANCE OF TRADE (US $ Billion)

Year 1990-91 2004-05 2009-10

Exports 18.5 85.2 182.2

Imports 27.9 118.9 300.6

Trade balance -9.4 -33.7 -118.4

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India’s export performance is poor. At present, India’s share of world export trade is 1%.

The share of exports of other developing countries is much more than India.

Reason for poor performance of India’s export Tarde:

There are several reasons for poor India’s performance. Some of them are:

A. Export- Related Problems:-

1. High Prices:

As compared to other Asian Countries the price of Indian Goods is high.

Prices are high due to documentation formalities, high transaction costs and also to make higher

profits.

2. Poor – Quality:

Many Indian exporters do not give much importance to quality control, so

their product are of poor quality. Due to low quality many times Indian goods are

rejected and sent back to India by Foreign buyers.

3. Poor Negotiation skills:

Indian exporters lack Negotiation skills due to poor training in marketing.

They fail to Convince and induce the foreign buyers to place orders.

4. Inadequate promotion;

For export marketing, promotion is important. Many Indian Exporters do

not give much importance to promotion. A good no. of Indian exporters are not professional in

advertising and sales promotion. They do not take part in trade fairs and exhibitions.

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5. Poor follow-up sales:

Indian exporters are ineffective in providing after- sales- service. They do

not bother to find out the reactions of buyer after sales. This results in poor performance of

India’s export trade.

B. General Causes:-

1. Good Domestic Market:

Sellers find a ready market for their good within the country, so they do

not take pains to get order from overseas market.

2. Number of formalities:

There are number of documentation and other formalities due to which the

some marketers do not enter the export filed. So there is a need to simplify formalities.

3. Problem of trading Blocs:

Trading blocs reduce trade barriers on member nations, but they impose

trade barriers on non-members. As India is not a member of some powerful trading blocs, it has

to face some problems.

4. Negative attitude:

Some of the overseas buyers have a negative attitude towards Indian

goods. They feel that Indian good are inferior goods. Thus there is a need to correct this attitude.

5. Poor infrastructure:

Indian infrastructure is poor. Indian exporters find difficult to get order

and also to deliver them at time.

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EQUILIBRIUM AND DISEQUILIBRIUM IN BOP:

Balance of payments is the difference between the receipts from and payments to

foreigners by residents of country. In accounting sense balance of payments must always

balance. Debit must be equal to credit. So, there will be equilibrium in balance of payments.

Symbolically, B= R – P

Where, B= Balance of payments

R= Receipts from foreigners

P= Payments made to Foreigners

When B= Zero, there is said to be equilibrium in balance of payments.

When B is positive there is favourable balance of payments; When B is negative is

unfavorable or adverse balance of payments. When there is surplus or deficit in balance of

payments there is said: to be disequilibrium in balance of payments. Thus disequilibrium refers

to imbalance in balance of payments.

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Types of Disequilibrium in BOP:

The following are the main types of disequilibrium In the Balance Of payments:

1. Structural Disequilibrium:

Structural disequilibrium is caused by structural changes in the economy affecting

demand and supply relation in commodity and factors markets. Some of the structural

disequilibrium are as follows:-

a. A shift in demand due to change in taste, fashion, income etc. would decrease or

increase the demand for imported goods thereby causing a disequilibrium in Bop.

b. If foreign demand for a country’s product declines due to new and cheaper substitutes

abroad, then the country’s exports will decline causing a deficit.

c. Changes in the rate of international capital movements may also cause structural

disequilibrium.

d. If supply is affected due to crop failure, shortage of raw materials, strikes, political

instability, etc. then there would be deficit in BOP.

e. A war or natural calamities also results in structural changes which may affect not

only goods but also factors of production causing disequilibrium In BOP.

f. Institutional changes that take place within and outside the country may result in BOP

disequilibrium. For e.g. if a trading block imposes additional import duties on

products imported in member of the block, then the exports of exporting country

would be restricted or reduced. This may worsen the BOP position of exporting

country.

2. Cyclical disequilibrium:

Economic activities are subject to business cycles, which normally have four phases

Boom or Prosperity, Recession, Depression and Recovery. During boom period, imports

may increase considerably due to increase in demand for imported goods. During

recession and depression, imports may be reduced due to fall in prices. During Boom

period, a country may face deficit in BOP on account of increased imports.

Cyclical Disequilibrium in BOP may occur because:

a. Trade cycles follow different paths and patterns in different countries.

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b. Income elasticity’s of demand for imports in different countries are not identical.

c. Price elasticity’s of demand for import differ in different countries.

3. Short – Run Disequilibrium:

This disequilibrium occurs for a short period of one or two years. Such BOP

disequilibrium is temporary in nature. Short-run disequilibrium arises due to unexpected

contingencies like failures of rains of favourable monsoons, strikes, industrial peace or

unrest etc. Imports may increase exports or exports may increase imports in a year due to

these reasons and causes a temporary disequilibrium exists.

International borrowings or lending for a short- period would cause short- run

disequilibrium in balance of payments of a country. Short term disequilibrium can be

corrected through short- term borrowings. If short- run disequilibrium occurs repeatedly

it may pave way for long run disequilibrium.

4. Long- run Secular Disequilibrium:

Long run of fundamental disequilibrium refers to a persistent deficits or a surplus in

the balance of payments of a country. It is also known as secular disequilibrium. The

causes of long- term disequilibrium are;

a. Continuous increase in demand for imports due to increasing population.

b. Constant price changes- mostly inflation which affected exports on continuous basis.

c. Decline in demand for exports due to technological improvements in importing

countries, and as such the importing countries depend less on imports.

The long run disequilibrium can be corrected by making constant efforts to

increase exports and to reduce imports.

5. Exchange Rate fluctuation:

A high degree of fluctuation in exchange rate may affect the BOP position. For

E.g. If Indian Rupees gets appreciated against dollar, then Indian exporters will receive

lower amounts of foreign exchange, whereas, there will be more outflow of foreign

exchange on account of higher imports. Such as situation will adversely affect BOP

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position. But if domestic currency depreciates against foreign currency, then the BOP

position may have positive impact.

CAUSES OF DISEQUILIBIRUM IN BOP:

Any disequilibrium in the balance of payments is the results of imbalance between

receipts and payments for imports and exports. Normally, the disequilibrium is

interpreted from a negative angle and therefore, it implies deficit In BOP.

The disequilibrium in BOP is caused due to various factors, some of them are

I. Import- related Causes

The rise in imports has been the most important factors responsible for large

BOP deficits.

The causes of rapid expansion of imports are:-

1. Population Growth:

Population Growth may increase the demand for imported goods such as food

items and non-food items, to meet their growing needs. Thus, increase in

imports may lead to BOP disequilibrium.

2. Development Programme:

Increase in development programmes by developing countries may require

import of capital goods, raw materials and technology. As development is a

continuous process, imports of these items continue for a long time landing

the developing countries in BOP deficit.

3. Imports of Essential Items:

Countries which do not have enough supply of essential items like Crude oil

or Capital Equipment’s are required to imports them. Again due to natural

calamities government may resort to heavy imports, which adversely affect

the BOP position.

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4. Reduction Of Imports Duties:

Hen imports duties are reduced, imports become cheaper as such imports

increase. This increase the deficit in BOP position.

5. Inflation:

Inflation in domestic markets may increase the demand for imported goods,

provided the imported goods are available at lower prices than in domestic

markets.

6. Demonstration Effects:

An increase in income coupled awareness of higher living standard of

foreigners, induce people at home to imitate foreigners. Thus, when people

become victim of demonstration effect, their propensity to import increase.

II. Exports Related Causes:

Even though export earnings have increased but they have not been sufficient

enough the meet the rising imports. Exports may reduce without a corresponding

decline in imports. Following are the cause for decrease in exports

1. Increase in population:

Goods which were earlier exported may be consumed by rising population.

This reduced the export earning of the country leading to BOP disequilibrium.

2. Inflation:

When there is inflation in domestic market, prices of export increases. This

reduces the demand of export of goods which in turn results in Trade Deficit.

3. Appreciation of currency:

Appreciation of domestic currency against foreign currencies results in lower

foreign exchange to exporters. This demotivates the exporters.

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4. Discovery of substitute:

With technological development new substitutes have come up. Like plastic

for rubber, synthetic fiber for cotton etc. This may reduce the demand for raw

material requirement.

5. Technological development:

Technological development in importing countries may reduce their imports.

This can be possible when they start manufacturing goods which they were

exporting earlier. This will have an advance effect on exporting countries.

6. Protectionist trade policy:

Protectionist trade policy of importing country would encourage domestic

producers by giving them incentives, whereas, the imports would be

discourage imposing high duties. This will affect exports.

III. Other Causes:

1. Flight of capital:

Due to speculative reasons, countries may lose foreign exchange or gold

stocks. Investors may also withdraw their Investments which in turn puts

pressure on foreign exchange reserves.

2. Globalization:

Globalization and the rules of WTO have brought a liberal and open

environment in global trade. Is has positive as well as negative effects on

imports, exports and investments. Poor countries are unable to cope up with

this new environment. Ultimately they become loser and their BOP is

adversely affected.

3. Cyclical Transmission:

International trade is also affected by Business cycles. Recession or

depression in one or more developed countries may affect the rest of the

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world. The negative effects of trade cycle (low income, low demand, etc.) are

transmitted from one country to other. For e.g. The current financial crisis in

U.S.A. is affecting the rest of world.

4. Structural Adjustment:

Many countries in recent years are undergoing structural changes. Their

economies are being liberalized. As a result, investments, income and other

variable are changing resulting in changes in exports and imports.

5. Political factors:

The existence of political instability may result in disrupting the productive

apparatus of the country the country causing in exports and increases in

imports. Likewise, payments of war expenses may also serious affect

disequilibrium in the country’s BOP. Thus political factors may also produces

serious disequilibrium in country’s BOPs.

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MEASURES TO CORRECT DISEQUILIBRIUM IN BOP:-

Any disequilibrium (deficits or surplus) in balance of payments is bad for normal internal

economics operations and international economics relations. A deficit is more harmful for a

country’s economic growth, thus it must be corrected sooner than later. The measures to correct

disequilibrium can be broadly divided into four groups:

Measures:

1. Monetary policy

2. Fiscal policy

3. Exchange rate policy

4. Non-monetary policy

Fiscal Policy and Its meaning:

Fiscal policy is one more important component of overall economic policy. Monetary policy

deals with the changes in demand for and supply of money where as fiscal policy is concerned

with non-monetary instruments. Fiscal policy, by employing its instruments, secures the

economic stabilization in developed economies and economic growth in underdeveloped

countries. Its instruments broadly consists of

I. Taxes

II. Public Borrowings

III. Public Expenditure

The importance of fiscal policy as an instruments of economic developments was first envisaged

by Keynes in his General Theory wherein he showed that the total national income was an index

of economic activity and brought out the relation between economic activity and total spending.

The direct and indirect effect of fiscal policy on aggregate spending in the community were in

clearly established and as a result the budgetary policy of the government as a weapon of

economic control and development came into prominence. But the Keynesian analysis of fiscal

policy is, applicable to the advanced and industrialized countries and it has little relevance to

understand countries.

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Let now look definition given by different economists. According to Arthur Smithies, fiscal

policy means, “a policy under which the government uses its expenditure and revenue programs

to produce desirable effects and to avoid undesirable effects on the national income, production

and employment.” GK Shaw has defined fiscal policy in these words, “We define fiscal policy

to encompass any decision to change to change the level, composition or timing of government

expenditure or to vary the burden, structure or frequency of the tax payments”. A skillful

management of fiscal policy instruments can go long way in maintaining economic stability and

ensuring higher rates of economic growth.

Objective of fiscal policy:

Objective of fiscal policy are as follows:

i. Securing the most efficient and rational allocation of economic resources

ii. Accelerating the rate of capital formation

iii. Controlling inflation

iv. Securing equitable distribution of income and wealth

v. Attaining and maintaining full employments

As like in monetary policy objective, fiscal policy objective also mutually consists but some

time there are conflicts between them. Therefore, policy must decide its course of action in

the light of the requirements of the situation prevailing in the country at the time.

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ROLE OF FISCAL POLICY TO CORRECT DISEQUILIBRIUIM:

Fiscal policy can be used to correct a disequilibrium in the balance of payments. A deficit in the

balance of payments can be cured by reducing expenditure. Contractionary fiscal policy can be

used to reduce expenditure. Two important instruments of fiscal policy are changes in tax rates

and government expenditure. An increase in tax rates, both direct and indirect taxes, will reduce

the income of the household which, in turn, will reduce the demand for goods and services.

Another instruments to reduce expenditure is cut government expenditure. This involves lower

deficits or higher budget surplus. It will decrease transfer payments such as old-age pension,

family allowances, etc. This will immediately reduce the consumption expenditure since the

groups receiving such benefits are generally the low- income groups with a high marginal

propensity to consume. A cut in government expenditure is also likely to reduce public

consumption and investment, which in turn, will lead to a fall in national income and imports.

Since prices are likely to fall due to reduction in demand it may encourage exports. This will

improve the balance of trade, current account balance and the balance of payments of the

country. Further, a contractionary fiscal policy will lead to fall in demand for money which in

turn will reduce the interest rates. This will lead to capital outflow in the short-run. This may

worsen the balance of balance of payments.

This combined effect of fiscal policy on the balance of payments is not predictable. It may

worsen first but eventually may improve. This is shown as follow:

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Effect of contractionary Fiscal policy On the Balance Of payments

On the other Hand, a surplus in the balance of payments can be corrected by a reduction in taxes

and an increase in government expenditure i.e. by expansionary fiscal policy. A reduction in

direct and indirect tax rates will stimulate the demand for goods and services. A reduction in

direct tax rates will increase the disposable income of the tax payers which will lead to an

increase in demand for goods and services. A reduction in direct taxes will enable the people to

buy greater amounts of goods and services from the given income. Similarly, an increase in

government expenditure will cause a direct increase in the total demand for goods and services.

This will cause an increase in income and therefore, increase in demand, it may discourage

Interest

Rate

Falls

Capital flows out

(In the short run)

BOP may

worsen first,

but improves

eventually

Contraction

ary fiscal

policy

Fall in Government

Expenditure or Rise in

Tax rates

Expenditure and

income falls

Imports

fall

Trade balance

and current

account balance

improves

Price level falls Exports Rises

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exports. In this way, expansionary fiscal policy can reduce the surplus or worsen the balance of

payments.

Expansionary fiscal policy is likely to increase the demand for money and the rate of interest.

This may encourage capital inflows in the short run which may improve the overall balance of

payments.

Thus, the expansionary fiscal policy may improve the balance of payments at first, but eventually

may worsen the balance of payments or reduce the surplus in the balance of payments.

This shown in follow:

Effect of Expansionary Fiscal policy On the Balance Of payments

Interest

Rate

Rises

Capital flows in

(In the short run)

BOP may

improve first,

but worsen

eventually

Expansionary

Fiscal policy

Rises in Government

Expenditure or fall in Tax rates

Expenditure and income rises

Imports rises

Trade balance

and current

account balance worsen

Price level

rises Exports Falls

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BIBILOGRAPHY

M.com Part- I Economic book By Johnson and Mascarenhas

Working paper on Disequilibrium In BOP By ChandraShekar (Scribd)

Notes On Monetary and Fiscal Policies By Prof. Akvchary (scribd)

Balance of payments Notes By Pruthviraj (Scribd)