Balance of payments block

The foreign sector is one of the most important sectors of any economy in the world as a whole. Unquestionably, that the Libyan economy is deeply dependent on the foreign sector, as has been mentioned previously, for the import of products required to keep up the development course of the economy. Additionally, this sector provides money resources to purchase those imports and fund development projects. This enables the State to follow these

129 transactions with the rest of the world termed, in economics, the balance of payments.

The balance of payments consists of three major accounts, which are the current account, the financial account, and the capital account, whereby, as is mentioned above ‘‘a country’s balance of payments accounts keep track of both its payments to and its receipts from foreigners’’ (Krugman, Obstfeld, and Melitz, 2012; 306). Each of these transactions must be recorded as a credit or a debit. A transaction is considered a credit if it results in a receipt of a payment from the rest of the world, while it is considered a debt if it leads to a payment to the rest of the world (Carbaugh, 2011).

It is worthwhile noting that, although the balance of payments theory dates back to the works of David Hume (1752), when he severely criticized the theoretical foundation of the mercantilists’ theory of international trade (Johnson, 1972), nevertheless, the real interest in analysing the effects of different economic policies on the balance of payments has been enhanced since the nineteen- thirties. Several approaches have emerged consecutively since that date, each of which attempt to explain and analyse the different positions of the balance of payments and, therefore, the influences of these varied conditions that result from the impact of various economic policies on the economy as a whole. In fact, one of the substantial objectives of these approaches mainly concentrates on the influence of devaluation on the status of the balance of payments (Johnson, 1977a). These theories can be arranged into the following subsections:

• Firstly, the elasticities’ approach that proposed by Robinson in 1937 and Machlup in 1955.

• Secondly, the absorption approach which developed by Alexander in 1952.

130 • Thirdly, the Mundell-Fleming approach that invented by Fleming in 1962

and Mundell in 1962 and continued in 1963.

• Fourthly, the monetary approach to the balance of payments developed by Dornbusch in 1973 and Whitman in 1975 and later on by Frenkel and Johnson in 1976, and

• Lastly, the portfolio balance approach which appeared for the first time in works of Oates in 1966, McKinnon in 1969 and later on in the work of Branson in 1974 (Johnson, 1977a,b; Matlanyane, 2005).

The first approach is the elasticities’ approach that arises from the early work of Robinson and Machlup in 1937 and 1955 respectively. This approach analyses the current account of the balance of payments from the perspective of the Marshall-Lerner condition, whereby it explores the influence of devaluation on the position of the current account.

According to the elasticities’ approach, the position of the current account will improve according to the following assumptions: the first is related to the simple model that assumes perfect elasticity of supplies with the initially balanced trade so that the sum of the elasticities of both exports and imports is greater than unity. The second is regarded a complex case, where it is ‘‘assuming independent elasticities of demands for imports and supplies of exports that a fearfully complex algebraic expression should satisfy but challenging to derive and explore’’ (Johnson, 1972; 1557).

With increase proposed in the inability of the elasticities’ approach should explain the different effects of devaluation on the current account, this approach was designed under the stimulus of the crisis of the Great Depression in the last century and it is no longer valid to interpret the current account imbalances in an environment beset by inflation. The absorption approach became a halfway house where depends on the analysis of elasticities and is incorporated within

131 the Keynesian multiplier theory, taking into account the circumstances of inflation (Johnson, 1977a).

This second approach confirms that the current account imbalance is caused by the difference between domestic absorption and domestic output and is based upon the current account deficit that occurs by an increase in absorption over the domestic output, and vice versa in the case of surplus (Matlanyane, 2005).

According to this method, the effect of devaluation on the current account is dependent on the degree of use of economic resources (employment) in the economy under consideration. Hence devaluation will increase domestic output compared to domestic absorption levels and it will then improve the current account position in the case of unemployed resources, and will assume that the conditions of the elasticities are favourable provided there is the marginal propensity to absorb less than one (Johnson, 1977a). In the case of the employment of resources, devaluation will increase domestic absorption over domestic production, which result in the deterioration of the current account position, on the one hand, and an outbreak of inflation in the economy, on the other. To recapitulate, the ultimate impact of devaluation on the current account depends on employment, and on the effect of changing the terms of trade, because of the devaluation effect on income(Matlanyane, 2005).

The third approach was developed independently as a product of the works of Marcus Fleming and Robert Mundell in the early nineteen-sixties (Boughton, 2003). In reality, this model has incorporated not only the effects of the interest rate on output (as in the analysis of an economy under autarky in the conventional IS-LM model), but also accounts for the effects of the exchange rate. Moreover, it has merged both the capital account of the balance of payments and the monetary sector in the analysis (Boughton, 2003; Matlanyane, 2005). The analysis of this approach is conducted under various exchange rate

132 regimes (e.g. fixed or flexible) with several monetary and fiscal policy scenarios such as changes in the money supply, government expenditure, or global interest rate, and exploring the results in each of these cases.

Economic policy makers, in the open economies, will be confronted by three critical challenges when they attempt to sketch an appropriate economic policy. In fact, the problem resides in how to attain irreconcilable goals at the same time, in effect , how to conduct an independent monetary policy directed to achieve domestic objectives and join in free global capital mobility, meanwhile stabilizing the exchange rates (Obstfeld, Shambaugh and Taylor, 2005) which is the so-called ‘Trilemma’ or ‘unholy trinity’ in economic literature. This ‘Trilemma’ is the theoretical background of the Mundell-Fleming model which considered one of the Keynesian approaches to modelling the balance of payments, which is also known as the IS-LM-BP model.

The fourth approach is the monetary approach to the balance of payments that developed in early nineteen-seventies, as mentioned above, by Dornbusch (1973), Whitman, and Frenkel and Johnson in 1975 and 1976 respectively.

In fact, the monetary approach relies on the ‘Walras's Law’ which is one of general equilibrium theories. According to Walras's Law, all excess market demands (and conversely, excess market supplies) must be equal to zero. In this regard, Johnson emphasized that,

the essence of the 'monetary approach' is most easily understood by reference to Walras's Law as used in contemporary theory, according to which the sum of the excess demands for goods, securities, and money is identically zero

(Johnson, 1977b; 259).

The essential consideration of this approach is analysing the balance of payments under a fixed exchange rates’ regime. The main assumptions of this

133 approach are, firstly, the real variables such as output and employment are balanced at their long-run equilibrium values. Secondly, the demand for money is a stable function, and lastly, ‘‘monetary inflows or outflows associated with surpluses or deficits are not sterilized -or cannot be, within a period relevant to policy analysis- but instead influence the domestic money supply’’ (Johnson, 1972; 1560).

Furthermore, there are three theoretical foundations underlying the monetary approach to the balance of payments. The first is that the balance of payments is a monetary phenomenon and, therefore, it must be analysed according to monetary theory tools, not by tools of the international trade theory. Secondly, ِ

as long as that money is stock, so the appropriate theory on the balance of payments must take into account both stocks and flows. Thirdly, alongside the domestic credit as a source for the money supply, the international reserve flows are considered as an additional source for the money supply, thus, the different policy implications are considered pivotal when requiring an analysis of the balance of payments (Johnson, 1977b).

The economic policy implications of this approach are different in the case of an open economy compared with that of a closed economy. However, attention is focused primarily on an open economy that could be recapitulated in what follows, considering the influence of an expansionist monetary policy. An increase in money supply will lead to an increase in the domestic expenditure, which, in turn, will transfer to the deficit in the balance of payments by increasing the demand for imports. The balance of payments’ deficit leads to a reduction in the money supply and that will decrease the excess holdings of money by the private sector, and this will eventually translate into reducing the domestic expenditure.

134 There are some criticisms of the monetary approach, two of which are directed at its theoretical assumptions. The first criticism negates the putative stability of demand for money, while the second denies the automatic response of the money supply to the needs of trade (Johnson, 1977a). There is another criticism concerned with the policy implications of this approach, where ‘‘the monetary approach is the impotence of monetary policy in its effects on domestic variables, while it becomes fully potent in its effects on the balance of payments’’ (Matlanyane, 2005; 55).

The last approach is the portfolio balance approach, which refers to a series of models that appeared in the late 1960s and early 1970s. This approach was a result of the contribution of many economists inter alia, as previously mentioned, Oates, McKinnon, and Branson, in 1966, 1969 and 1974, respectively.

The portfolio balance approach stems mainly from the monetary approach to the balance of payments, and developed, on the one hand, by taking into consideration liquid assets and relying on the model of international portfolio diversification and, on the other hand, by combining the role of the effect of wealth and the capital account stock theory (Matlanyane, 2005). This approach in its origins is an attempt to introduce a clear exposition for the relationship between the changes in the exchange rate and the current account of the balance of payments (Isaac, 2012). Furthermore, the model works in the light of the interaction between banking systems and private sectors at home and abroad (Taylor, 2004). Unlike the monetary approach to the balance of payments, the portfolio balance approach not only focuses on the movements in the demand for, and supply of, money but also takes account of the demand and supply relationships between other financial assets (Cross, 1998).

135 This approach assumes that there is no perfect substitution between the foreign and domestic bonds; furthermore, it assumes that all markets are automatically cleared. Additionally, it assumes that the market participants are able to choose the appropriate combination of portfolio. The choice is based on some preferences and constraints such as wealth, tastes, the level of domestic and foreign interest rates and on expectations of the inflation and interest rates. The portfolio balance approach depends on the effects of changing both interest rates and wealth. Finally, the portfolio balance approach assumes that the market participants are able to adjust their financial assets when any change occurs in the market conditions upon which the portfolio has been built (Cross, 1998). The policy implication of the portfolio balance approach is concentrated on analysing the adjustment process of the portfolio that results from monetary disequilibria. Therefore, the portfolio policy implications can be depicted in what follows.

From the portfolio policy prospective, an expansionist monetary policy decreases the domestic interest rate and activates the effect wealth. This will increase the demand for foreign financial assets according to the degree of the financial assets’ substitution and the magnitude of the portfolio multiplier (Matlanyane, 2005). In terms of the balance of payments, this would lead to the deterioration of the current account and hence to depreciation in the domestic currency. Accordingly, this devaluation in the domestic currency increases exports and reduces imports, which will eventually lead to an improvement in the current account. Therefore, any disequilibria that occur in the current account would be adjusted because of the contradiction between the domestic currency depreciation and the effect of wealth (Cross, 1998).

There are several criticisms are directed against this approach but the most important one is the rejection of the assumption, which concerns the automatic

136 clearance of financial markets; this is not applicable in developing countries due to the immaturity of the financial markets in these countries. The second most important criticism is the neglect of the real sector in this approach.

The review of the balance of payments relationships in this study consists of two behavioural stochastic equations and six identities, as follows:

4.2.2.1 Net financial income from abroad

The first behavioural equation is the net financial income from abroad (NFIFBC) and is described by the following function, where the explanatory variables are:

NFIFBC = F (NFIFBC_1, FINACC)

Where:

NFIFBC = Net financial income from abroad,

NFIFBC_1 = Lagged net financial income from abroad, and

FINACC = Financial account balance in the balance of payments

4.2.2.2 Net compensation of employees from abroad

The second equation is the net compensation of employees from abroad

(WAGEFBC) which is explained by

WAGEFBC = F (WAGEFBC_1, FLABOR)

Where:

WAGEFBC = Net compensation of employees from abroad,

WAGEFBC_1 = Lagged net compensation of employees from abroad, and

FLABOR = Foreign labour force (thousands).

4.2.2.3 Total Exports

EXTOTC = EXOILC + EXOTHERC

137

EXTOTC = Total Exports,

EXOILC = Oil exports in millions of dinars, and

EXOTHERC= Exports of other goods.

4.2.2.4 Total imports

IMTOTC = IMCONR/PIMC + IMCAPR / PIM + IMOTHERC

Where:

IMTOTC = Total imports

IMCONR = Real imports of consumer goods

PIMC = Imports’ price index of consumer goods

IMCAPR = Real imports of capital goods

PIM = Total imports’ price index

IMOTHERC = Other imports

4.2.2.5 Net income from abroad

NETYFBC = WAGEFBC + NFIFBC

Where:

NETYFBC = Net income from abroad,

WAGEFBC = Net compensation of employees from abroad, and

NFIFBC = Net financial income from abroad.

4.2.2.6 Balance of trade, current (goods and services)

BOTGSC = EXTOTC – IMTOTC Where:

BOTGSC = Balance of trade, current (goods and services),

138

IMTOTC = Total imports.

4.2.2.7 Balance of payments, current

BOPC = BOTGSC – NETYFBC + FINACC + BOPOTHC

Where:

BOPC = Balance of payments, current,

BOTGSC = Balance of trade, current (goods and services),

NETYFBC= Net income from abroad,

FINACC = Financial account balance in the balance of payments, and

BOPOTHC = Other balance of payments’ items.

4.2.2.8 The balance of foreign assets (reserves)

IRC = IRC_1 + BOPC

Where:

IRC = Balance of foreign assets (reserves),

IRC_1 = Stock of the balance of foreign assets (reserves), and

BOPC = Balance of payments, current.