Topic 2: Autonomous and Induced Transactions: Balance of Payments Equilibrium

The balance of payments has a dimension that goes beyond the mere tracking of transactions. The relationship between the balance of payments and the exchange rate is much deeper than can be understood in an accounting framework---with total payments always identically matched by total receipts there would seem to be no reason for the exchange rate to change. We must therefore make a distinction between two types of payments and receipts---autonomous and induced.

One would think that if payments were to increase relative to receipts that there would be an excess demand for foreign currency and an excess supply of domestic currency on the international currency market and that, as a result, the price of domestic currency in terms of foreign currency would be bid down. Correspondingly, if receipts were to increase relative to payments there would be upward pressure on the international value of the domestic currency in terms of foreign currency. But the principle that the balance of payments always balances implies that receipts will ultimately always equal payments! How do we reconcile this?

It is very important to distinguish between desired and actual receipts and payments. An increase in desired payments relative to receipts would cause the domestic currency to depreciate and an increase in desired receipts relative to payments would cause it to appreciate. When the exchange rate is allowed to respond to the market forces of supply and demand, the movement in the exchange rate in response to these discrepancies between desired receipts and payments will cause transactors to moderate their desires so as to bring desired receipts and payments into equality. Actual and desired receipts and payments will then all be the same. If this did not happen, the foreign exchange market would not be in equilibrium.

Governments frequently interfere in the markets for foreign exchange to prevent exchange rates from responding to the market forces of supply and demand. They often fix the price of the domestic currency in terms of a particular foreign currency at a fixed level or parity. Under these circumstances, the desired receipts and payments of the aggregate of private individuals and firms will not necessarily be equal. If the government passes a law fixing the exchange rate and does nothing else there will be two exchange rates---the official rate established by the government and a black market rate which anyone who wants to actually make a transaction will end up having to pay. The black market exchange rate will adjust to equalize desired receipts and payments, but the official rate will not.

If the government wants to keep the market exchange rate equal to an official rate, it must either punish people who transact at exchange rates other than the official rate or buy and sell domestic currency for foreign currency on the international market to eliminate any discrepancies between desired receipts and payments. Since punishment is almost never effective when there are significant discrepancies between the black market and official exchange rates, the government has to adopt the latter course.

Governments keep stocks of official reserves of foreign exchange for use in maintaining the exchange rate at the official level. When there is excess supply of the domestic currency on the foreign exchange market the government sells foreign currency out of its reserves in return for the domestic currency; when there is an excess demand for the domestic currency it buys foreign currency and supplies domestic currency, adding to its stock of official reserves.

Here we must distinguish between autonomous and induced transactions. Autonomous transactions are defined as transactions that are made for reasons other than the government's desire to fix or otherwise manipulate the exchange rate and induced transactions a those that are made as a result of the government's exchange rate manipulations. Autonomous transactions can include government as well as private sector transactions---as when the government purchases military equipment from abroad or sends athletes to the Olympic games. Private transactions can also have an induced component---when for example, expenditures abroad on tourism are reduced because domestic residents are legally allowed to purchase only a limited quantity of foreign funds to spend on their travels. For now we will assume that changes in the stock of official foreign exchange reserves are the only induced transactions---all other transactions are autonomous.

When there is no government intervention in the foreign exchange market---that is, when the stock of foreign exchange reserves is neither increasing nor decreasing through time, autonomous receipts will equal autonomous payments and induced transactions will be zero. This situation is called balance of payments equilibrium. When autonomous payments exceed autonomous receipts and the government is selling foreign exchange out of its reserves in return for domestic currency, there is a balance of payments deficit. When autonomous receipts exceed autonomous payments, and official reserves are increasing through time, there is a balance of payments surplus. The balance of payments always balances, of course, because any discrepancy between autonomous receipts and payments is offset by induced transactions in foreign exchange. And, although the balance of payments may not be in equilibrium, the foreign exchange market always will be since induced transactions are desired transactions by the government that offset the discrepancy between autonomous desired receipts and payments. Total desired receipts will therefore equal total desired payments.

All this is summarized in the following table which is designated as Table 2 to distinguish it from Table 1 in the previous Topic which is identical except for the definition of the items in the capital account. Purchases of securities by domestic residents from foreigners and sales of assets to foreigners are now defined to include only autonomous transactions. The net change in official reserves is an induced item which is entered as a (positive or negative) accumulation of foreign exchange reserves (purchase of foreign assets) in the debit column. This reserve accumulation represents an induced net capital outflow that makes up the difference between the (autonomous) current account surplus and the autonomous net capital outflow.

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