2. What is Balance of payments? Describe the components of balance of payments with hypothetical examples. How do deficit and surplus in Balance of payments affect international trade? Discuss with suitable examples.
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COURSE CODE : IBO-01
COURSE TITLE : International Business Environment
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2. What is Balance of payments? Describe the components of balance of payments with hypothetical examples. How do deficit and surplus in Balance of payments affect international trade? Discuss with suitable examples.
Answer 2
The Balance of Payments (BoP) can be considered as a giant notebook that the country uses to record all monies earned and spent with other countries. It's also very much like a mammoth-sized ledger wherein we record every single money going in and out of the country. It will enable the nation to understand how much more money it earns or, rather, more money it spends when dealing with other nations.
Just as you keep track of your allowance and spending, nations must keep track of their money too. The Balance of Payments has two principal sections, which are akin to two pages of that notebook. There are two main sections:
1. The Current Account
2. The Capital and Financial Account
Let's break them down with some easy examples!
1. The Current Account : This is like the "money box" where all the daily trades and exchanges are written down. It mainly keeps track of:
a) Trade of goods and services (Trade Balance) : This is about things that are bought and sold between countries. It's split into two parts: goods and services.
- Goods : Every time a country sells goods to another country, such as cars or bananas or toys, then it's called an *export* and gets money. Every time it buys goods, such as chocolates, clothes, or mobile phones, then it is called an *import* and loses money.
Example : Suppose the country of Toyland sells $100 million in robot toys to another country Foodland , and receives in return, $50 million in chocolates from Foodland. Toyland is making more dollars from selling toys than it is expending on chocolates, so Toyland has a *positive* trade balance.
- Services : Just as the case with goods, services are also bought and sold. For example, a country can buy travel services like vacationing, or even computer services, from other countries.
Example : Toyland benefits Foodland in designing video games. Toyland earns $20 million providing this service. But Toyland spends the cost of $10 million by sending students to study in the schools of Foodland. So Toyland is earning more money than it spends in services once again.
- Income : Money earned by people or companies in one country, from investments in another country. Consider the example of income, where a person in Toyland owns a factory in Foodland. The income would be brought back to Toyland.
Example : Toyland owns a toy factory in Foodland and earns a profit of $5 million from it. At the same time, some people of Foodland have invested in Toyland's chocolate factory, and they earn a profit of $3 million from that factory. Toyland earns higher income from Foodland than it sends out to it.
Transfers: It includes the flow of funds from one country to another as donations or assistance. This does not include any trade or investment; it is just money passing between nations.
Example : Toyland sends $1 million in order to raise schools for Foodland. This is known as a transfer, and it is included in the BoP although Toyland does not gain anything through this transaction.
2. The Capital and Financial Account : The capital and financial account details investments and large inflows of funds. This is in many ways, a running tally of every big deposit or withdrawal you make into your piggy bank or savings account.
- Capital Account : It represents all other small transactions that are not the buying or selling of a good. Like how you may donate some money to a country so that it builds a bridge or cancels debts with another country.
For example, Toyland forgives a $10 million debt that Foodland owes it. This is an entry in the capital account because it changes Toyland's net position.
- Financial Account : These accounts monitor all large investments by companies when companies purchase buildings or other land or buy other companies including other countries when countries lend or borrow funds.
- Direct Investment : This is when people or companies in one country invest money to start or buy businesses in another country.
Example: Toyland buys a toy factory in Foodland for $30 million. That is a direct investment that means Toyland owns part of the toy industry in Foodland.
- Portfolio Investment : This is an investment made by people or firms in the stocks or bonds of another country.
Example: Some rich individuals in Toyland buys $5 million worth of stocks in a Foodland technology company. They do not own the whole company but small pieces of it.
- Other financial flows. Loans and deposits. Any time a country has money in international banks or lends money to other nations, that's recorded here.
Example: Toyland lends $20 million to Foodland to build more schools. That loan is eventually going to be repaid and it's tracked on the financial account.
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# How the Balance of Payments Works Together
The balance of payments is like a big balancing scale. If one side becomes too heavy, then something has to be done about it.
- A Positive BoP : If Toyland earns more money than it spends, then its balance of payments is positive. It can invest in other countries, save, or lend to a country like Foodland.
- Negative BoP : When Toyland earns less than what it spends, the country is said to have a negative balance of payments. In this case, it must borrow money from other countries or sell some of its investments in order to cover up for the difference.
Example : For instance, Toyland sold $100 million worth of toys but bought only $50 million worth of chocolates in Foodland. Therefore, there is a greater positive balance of returns and less consumption where Toyland is concerned, and that has a positive balance of trade. If instead, Toyland started to purchase loads of goods and services from other nations without selling much in return, they would eventually exhaust all their funds, and thus it would be a negative balance of payments.
Why Is the Balance of Payments Important?
1. Keeps the Economy in Check : A balance of payments is crucial to inform a country whether or not it lives within its means. If a country is spending much more than it is earning, then it might have to slow down or change a few things before getting into serious financial trouble.
2. Foreign Exchange Rates : If the country's balance of payments is positive, it will affect the value of the money compared to other currencies. In this scenario, for instance, in case Toyland exports much and earns money, then Toyland's currency will eventually become stronger than Foodland's currency in the long run.
3. Foreign Direct Investments : A high balance of payment attracts more foreign direct investments. Other countries may want to put investments into the business or lend it money at better rates if they discover that Toyland is earning good amounts of money.
Let's break down how a deficit and a surplus in the BoP affect international trade by using easy examples to understand it better.
1. Deficit in Balance of Payments
A deficit is when a country is spending more dollars than it's taking in. Suppose you have an allowance of $10, but you're spending $15 every week. You will be broke instantly unless you borrow some from your friends or family. That's pretty much what happens to countries.
# Example: Toyland's Deficit
Suppose that Toyland imports enormous amounts of chocolates, clothes, and video games from abroad and it has cost $200 million. Then its exports stand at merely $150 million that comprises toys and everything else. Thus, Toyland is spending $50 million more than what it is earning-it is said to have a BoP deficit.
When a country has a deficit, it may have to borrow money from other countries or international banks. Some things are attached with this:
- Weaker Currency : Since Toyland spends more money on imports, the value of its currency could reduce as well in comparison to other countries. A Toyland dollar will now buy fewer chocolates from Foodland. Imports are now costlier.
Changes in Trade: Due to the devaluation of the currency, the other countries would be able to buy toys at lower prices. As such, Toyland would spend much in buying from other countries. However, for Toyland, its imports would become costly to buy. In this way, Toyland might reduce its imports or orient itself in the purchase of more local products.
- Debt : Toyland might borrow money to fill the gap. But if it keeps borrowing without addressing the problem, then it may have a lot of debt, which will be hard to refund.
Effect on International Trade:
A deficit may make Toyland export more since their products will be cheaper to other countries. Less money from Toyland, however, will have to be spent on importing goods, thus damaging the interests of international firms that rely on selling products to Toyland.
2. Surplus in the Balance of Payments
A surplus occurs when a country earns more money than it spends. It is equivalent to the earning of an allowance of $10, but spending only $7 so one saves $3 every week. Extra money is also what a nation with a surplus has to invest or lend to other countries.
# Example: Foodland's Surplus
Now let's turn to Foodland, a country that produces a lot of chocolates, cakes, and fruits. Other countries love Foodland's sweets and spend $250 million buying goods from Foodland annually. Foodland, on the other hand, spends $200 million importing goods such as clothes, electronics, and toys. This means Foodland is taking in $50 million more than it's spending, which means Foodland is in BoP surplus.
A country, when it has a surplus, will have some positive effects:
- Stronger Currency : Because of the surplus generated by exporting more from Foodland, there will be an increase in the value of its currency. Hence, it requires fewer expenses for importing commodities. For example, Foodland's currency can now buy more toys from Toyland than previously.
- Other Country Investments : With additional capital, Foodland can invest in other countries' companies, lend money to struggling businessmen, or even purchase companies overseas. This will increase its power in international markets.
Effect on International Trade:
A surplus does help Foodland import goods from other countries easily, which bodes well for Toyland or any other countries whose products are being sold. But when Foodland's currency grows to be too strong, its exports – chocolates in this case – might become too expensive for another country to buy. This may cut down the goods sold abroad by Foodland and affect its businesses being exported.
Conclusion
The Balance of Payments is a very important instrument for any country. One learns how much money is being entered versus how much is leaving the country when it trades or invests with others. Understanding it allows countries to keep up with their finances, attract investments, and keep the economy healthy. Whether it's tracking exports of toys or importing chocolates, knowing where the money goes keeps Toyland (and any real country) running smoothly!
A deficit or a surplus of Balance of Payments has several significant effects on international trade.
- Deterrent effect for borrowing a deficit, weakening the country's currency, lowering the number of imports, and making the country's goods cheaper for others to buy.
Excess provides a country with extra monies to invest and import more but could make home products too expensive for other countries, thereby lowering the exports.
Every nation keeps trying to maintain its Balance of Payments so it can trade effortlessly with the rest of the world without running into financial woes.
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