Balance of Payments: Theory, Policy, and Institutions
Balance of Payments: Theory and Policy
The Balance of Payments, also known as Balance of International Payments (BoP), of a country is the record of all economic transactions between the residents of the country and the rest of the world in a particular period. Transactions are made by individuals, firms, and government bodies; they include payments for the country’s exports and imports of goods, services, financial capital, and financial transfers.
Balancing Mechanisms
If the current account is in deficit (or surplus), a specific mechanism is required to bring it back into balance. BoP’s mechanisms of adjustment can be automatic (spontaneous economic processes) and discretionary (conducted economic policy).
Automatic Mechanism
This is a classical approach emphasized under the terms of the so-called Gold Standard, by which the value of a currency was defined in terms of gold. The prices of domestic currencies were fixed to a specified amount of gold, and exports and imports were paid and charged in gold as well.
Discretionary Mechanism
Economic policy measures for achieving external balance include monetary policy, fiscal policy, and exchange rate policy.
There are three approaches to balance the BoP under the discretionary mechanism:
- The Elasticity Approach
- The Absorption Approach
- The Monetary (and Portfolio) Approach
Elasticity Approach
- It emphasizes price changes as a determinant of a nation’s balance of payments and exchange rate.
- The elasticity approach is helpful in understanding the different outcomes that might arise from the short to long term.
Absorption Approach
This approach emphasizes changes in real domestic income as a determinant of a nation’s balance of payments and exchange rate.
Portfolio Approach
- Assumes that individuals earn interest on the securities they hold, but not on money.
- Assumes that households have no incentive to hold the foreign currency.
- Hence, wealth (W) is distributed across money (M) holdings, domestic bonds (B), and foreign bonds (B*).
International Financial Institutions (IFIs)
An International Financial Institution (IFI) is a financial institution established by more than one country, and hence is subject to international law. The best-known IFIs were established after World War II to assist in the reconstruction of Europe and provide mechanisms for international cooperation in managing the global financial system.
Types of IFIs include:
- Multilateral Development Banks
- Bretton Woods Institutions
- Regional Development Banks
- Bilateral Development Banks and Agencies
- Other Regional Financial Institutions
Multilateral Development Banks (MDBs)
A Multilateral Development Bank (MDB) is an institution created by a group of countries that provides financing and professional advising for the purpose of development. MDBs have large memberships including both developed (donor) countries and developing (borrower) countries.
Examples of MDBs:
- World Bank
- European Investment Bank
- European Bank for Reconstruction and Development
Bretton Woods Institutions
The best-known IFIs were established after World War II to assist in the reconstruction of Europe and provide mechanisms for international cooperation in managing the global financial system. They include the World Bank, the IMF, and the International Finance Corporation. Today, the largest IFI in the world is the European Investment Bank, which lent 61 billion euros to global projects in 2011.
Regional Development Banks
These consist of several regional institutions that have functions similar to the World Bank group’s activities but with a particular focus on a specific region.
Bilateral Development Banks and Agencies
This is a financial institution set up by one individual country to finance development projects in a developing country and its emerging market, hence the term bilateral, as opposed to multilateral.
Other Regional Financial Institutions
Financial institutions of neighboring countries established themselves internationally to pursue and finance activities in areas of mutual interest. Most of them are central banks, followed by development and investment banks.
Evolution of the International Monetary System
Gold Standard
The great strength claimed for the gold standard was that it contained a powerful mechanism for simultaneously achieving balance-of-trade equilibrium by all countries.
Bretton Woods
44 countries met to design a new international monetary system in 1944, establishing the International Monetary Fund (IMF) and World Bank (WB).
International Monetary Fund (IMF)
The IMF is an international organization headquartered in Washington, D.C., of “189 countries working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world.”
The Washington Consensus are conditions made by the IMF, which are a set of policies the IMF requires in exchange for financial resources. Some of the conditions for structural adjustment can include: cutting expenditures (austerity), focusing economic output on export and resource extraction, devaluation of currencies, trade liberalization, increasing the stability of investment, removing price controls and state subsidies, privatization of all or part of state-owned enterprises, enhancing the rights of foreign investors vis-à-vis national laws, improving governance, and fighting corruption.
World Bank
The World Bank is an international financial institution that provides loans to developing countries for capital programs. It comprises two institutions: the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA). The World Bank is a component of the World Bank Group, which is part of the United Nations system. The World Bank’s stated official goal is the reduction of poverty. According to its Articles of Agreement, all its decisions must be guided by a commitment to the promotion of foreign investment and international trade.
World Bank Group
This is an extended family of five international organizations: IBRD, IDA, IFC, MIGA, and ISCID. All of the 193 UN members and Kosovo that are WBG members participate at a minimum in the IBRD.
The European Bank for Reconstruction and Development (EBRD)
The EBRD is an international financial institution founded in 1991. As a multilateral developmental investment bank, the EBRD uses investment as a tool to build market economies. Despite its public sector shareholders, it invests mainly in private enterprises together with commercial partners. The EBRD is owned by 65 countries from five continents, as well as the European Union and the European Investment Bank.
European Investment Bank (EIB)
The EIB is the European Union’s nonprofit long-term lending institution established in 1958 under the Treaty of Rome. As a “policy-driven bank” whose shareholders are the member states of the EU, the EIB uses its financing operations to bring about European integration and social cohesion. The EIB is a publicly owned international financial institution, and its shareholders are the EU member states. It is the world’s largest international public lending institution.