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Chapter 24: Problem 3

"The balance of payments of a country will always balance because of the double entry system of bookkeeping'. Explain.

Short Answer

Expert verified
Answer: The double entry system of bookkeeping ensures that the balance of payments always balances by requiring that for every transaction, there is an equal and opposite entry in two different accounts. This means that if a country has a surplus in its current account, it must have a deficit in its capital account, and vice versa, ensuring that the total balance is always zero.

Step by step solution

01

1. Understanding the Balance of Payments

The balance of payments (BOP) is a record of all economic transactions between a country and the rest of the world over a specific period of time, typically a year. The BOP consists of two main accounts: the current account and the capital account (sometimes also called the financial account). The current account records transactions that involve goods, services, investment income, and current transfers. The capital account records transactions that involve financial assets and liabilities, such as investments, loans, and changes in foreign exchange reserves.
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2. The Double Entry System of Bookkeeping

The double entry system is an accounting system in which for every transaction, there is an equal and opposite entry in two different accounts. This means that if a country imports goods worth \(1000, there must be an equal and opposite entry of \)1000 somewhere else in the BOP, such as an increase in liabilities or decrease in assets. The double entry system ensures that the sum of all transactions is always zero.
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3. How the BOP Balances

Due to the double entry system of bookkeeping, the balance of payments of a country will always balance. Every transaction in the current account has an equal and opposite transaction in the capital account, ensuring that the total balance is zero. If a country has a surplus in its current account, it must have a deficit in its capital account, and vice versa. For example, if a country has a current account surplus (meaning it exports more goods and services than it imports), it must have a capital account deficit (meaning it invests more in foreign assets than foreigners invest in its domestic assets). This ensures that the balance of payments always balances.

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Most popular questions from this chapter

What does the current account of the balance of payments measure? Discuss the constituent of the current account of the balance of payments.

Autonomous transactions are those transactions that take place independently of other items in the balance of payments.

According to the Marshall-Lerner condition, for a devaluation to have a positive effect on a country's balance of payments, the sum of the absolute values of the elasticity of demand for its exports and imports should be greater than one.

Briefly discuss the different kinds of disequilibria in the balance of payments.

Structural disequilibrium occurs due to business cycles.
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