If overall balance (current plus capital) is in deficit, this implies either a reduction in
reserves or an increase in foreign debt or reduction of credits. It is important to note that,
by convention, a deficit is shown by + sign. In other words, it appears on the sources
side. As a result, sum of all sources and uses becomes equal. The reverse is true when
the overall balance (i.e., the sum of current and capital account) is in surplus.
If a country has significant deficit, it will have a tendency to take stiff measures for
diminishing is imports, exchange control.
BOP provides foresight regarding the type of exchange rates (increase/decrease) to
prevail; consistent deficit of BOP has an unfavorable effect on exchange rate/
Devaluation etc., BOP statements may be prepared in two currencies.
Adjustments between demand for and supply of foreign currency take place through the
intervention of central bank, or market, or by administrative measures.
Central bank intervenes through its regulatory stocks. This exercise is necessitated to
control the volatility of exchange rate as and when it anticipates a surplus over demand
(surplus of the BOP) or vice versa.
The national income (or product) is the sum of consumption and savings, that is;
National Income = Consumption + Savings (2.1)Similarly, national spending consists of consumption and investment;National Spending = Consumption + Investment (2.2)From Eqs (2.1) and (2.2). We obtain:National Income – National Spending = Savings – Investment (2.3)This identity says if a nation’s income exceeds its spending, then, savings will exceed
domestic investment, yielding surplus capital. This surplus capital must be invested
overseas. In other words, a nation that produces more than it spends, will save more than
it invests domestically and will have a net capital outflow. This capital outflow will
appear as a combination of capital account deficit and an increase in official reserves.
Conversely, a nation that spends more than it produces will invest domestically more than
it saves and have net capital inflow. This capital inflow will appear as a combination of
capital account surplus and a reduction of official reserves.