ECONOMICS CLUB CAPSULS FOR UNDER ACHIEVERS UNIT :10 BALANCE OF PAYMENTS AND FOREIGN EXCHANGE RATE

Balance of Payments 7 marks Balance of Payment Account : A Balance of Payment Account is a systematic record of all economic transactions between residents of a country and the rest of the world carried out in a specific period of time. Components of Balance of Payment Account : 1. Export and import of goods. (visible items). 2. Services rendered and received (invisible items). 3. Unilateral transfers. 4. Capital receipts and payments. Balance of Trade : It is the difference between the money value of exports and imports of material goods. (called visible items or merchandise). Balance of Payment : It is the difference between a nations total payments of foreign countries and its total receipts from them. Current Account of Balance of Payment : The current account is that account which records imports and exports of goods, services and unilateral transfers. Capital Accounts of Balance of Payment : The capital accounts of BOP records all such transactions between residents of a country and the rest of the world which cause a change in the assets or liability status of residents of a country or its government. Components of Current Account : (i) Export and Import of goods (visible trade) (ii) Export and import of services- non factor and factor services (called invisible trade) (iii) Unilateral transfers (transfer receipts/payments). (iv) Investment income (factor income from land, bonds, shares abroad). Components of Capital Accounts : (i) Private transactions : (ii) Official transactions : (iii) Direct investment : (iv) Portfolio investment : Autonomous Items in BOP : These refer to international economic transactions that take place due to some economic motives like profit maximisation. Such transactions are independent of the state of countrys BOP. These items are generally called above the line items in BOP. Accommodating items in BOP : These refer to transactions that take place because of other activity in BOP like government financing. Deficit in BOP : It refers to current account of BOP. If autonomous receipts are less than autonomous payments, the BOP is in deficit reflecting disequilibrium in BOP. FOREIGN EXCHANGE RATE

Meaning And Determination. Meaning:- Foreign exchange rate is the price of one currency is terms of another. Foreign Exchange Market : The foreign exchange market is the market where the national currencies are traded for one another. Function of Foreign Exchange market: 1. 2. 3. Transfer function Credit function Hedging function. Transfer Function : it transfers the purchasing power between countries. Credit Function : It provides credit channels for foreign trade. Hedging Function: It protects against foreign exchange risks.

1) 2) 3)

DEMAND AND SUPPLY FOR FOREIGN EXCHANGE

DEMAND FOR FOREIGN EXCHANGE It is the demand for foreign currencies by the residents of a country. Transactions in the foreign exchange market are reflected in the balance of payments account.

1)
(i) (ii) (iii) (iv)

DEMAND SIDE : People desire to have foreign exchange for the following reasons:To purchase goods and services from other countries. To send gifts abroad. To purchase financial assets. To speculate on the value of foreign currencies. SUPPLY SIDE ; - Foreign currencies , flow into the domestic economy due to the following reasons . Foreigners purchasing have countrys goods and services through exports. Foreign investment in home country. Foreign currencies flow into the economy due to currency dealers and speculators.

2)
(i) (ii) (iii)

EQUILIBRIUM IN THE FORIGN EXCHANGE MARKET Foreign exchange market like any other normal market contains a downward sloping demand curve and an upward sloping supply curve . The price is shown on the vertical axis and the horizontal axis measures the quantity demanded or supplied . The intersection of the supply and demand curve determines the equilibrium exchange rate ( Reg) and the equilibrium quantity (Qeg) of foreign currency i.e. US ($) S$ D$

Price

R1

Of $ (in Equi Rs)

R2

Price

Equi. Q

Demand and Supply Of US $

TYPES OF EXCHANCE RATE Fixed Exchange Rate Systems : Under this system exchange rate is officially declared and it is fixed only a very small deviation from this fixed value is possible. A typical fixed exchange rate system was associated with the Gold Standard Systems of 1880-1914. under this systems value of currency was fixed in terms of Gold. For :- Re $ = = 125 gm Gold 25 gm gold

50,

Re

5$

FLEXIBLE EXCHANGE RATE SYSTEM: Flexible exchange rates point to an extreme situation where there is no intervention by Central Banks. The foreign exchange market is busy at all times by changes in the exchange rates.

ADVANTAGE OF FLEXIBLE EXCHANGE RATE SYSTEM (i) (ii) (iii) Flexible exchange rates eliminate the need fore central banks to hold international reserves. Helpful to do away with barrier to trade. Enhances the efficiency in the economy.

Number of alternative system has been suggested as hybrid systems combining advantages of fixed and flexible exchange rates.

MANAGED FLOATING: The final hybrid in management of fixed and flexible exchange rates is the managed floating. The intervention is discretionary on the part of monetary authorities.

OPERATION OF FOREIGN EXCHANGE MARKET Operation of Foreign exchange market are of two types : 1) Current market for the spot market . 2) Forward market.

1) SPOT MARKET FOR FOREIGN EXCHANGE:-

Spot rate of foreign exchange is useful for current transactions. It is also important to find the strength of the domestic currency. The measure of average relative strength of a given currency is called the effective exchange Rate (EER). As we do not climate the effect of price changes, this may also be called as Nominal effective Exchange Rate (NEER). And when we eliminate the effect of price changes, this is real exchange rate (RER) Real effective exchange Rates ( REER) is based on real exchange rates. Another of the spot rate is Purchasing Power Parity (PPP). There are two versions of it:1) 2) Absolute purchasing power parity. Relative purchasing power parity. Absolute Purchasing power parity: It considered the same price of commodity in the whole world. Relative purchasing power parity:- It considered the rates of inflation in the two countries. Forward Market for foreign exchange:- The forward market for foreign exchange covers transactions which

1) 2) 3)

occur at a future date. Most of the international transaction does not occur on same day. Usually they materiablise much later. A forward contract is entered into for two reasons: 1) To minimize risk of loss. 2) To make a profit Any problem with the exchange rate could create enormous difficulties not only for the country concerned but to others as well. 1 mark questions. 1. What is meant by balance of trade? Balance of trade refers to the difference in the value of imports and exports of visible items. 2. Define balance of payments.
A Balance of Payment Account is a systematic record of all economic transactions between residents of a country and the rest of the world carried out in a specific period of time.

3.

Name two invisible items of current account of balance of payments.

Banking and shipping insurance. 4. Define balance of payment on current account? It refers to all receipts and payment transactions relating to trade in goods, services and unilateral transfers. 5. Is balance of payment always balanced? Balance of trade can be favourable or unfavourable but balance of payment is always balanced. 6. Define foreign exchange rate? Foreign exchange rate is the price of one currency is terms of another 7. What is fixed exchange rate? It is a system in which exchange transactions take place at a rate fixed by monetary authorities. 8. What is flexible exchange rate? It is a system in which the value of one currency in terms of another is freely determined by demand and supply of foreign exchange. 9. Define foreign exchange market? The market at which different currencies are exchanged with one another. 10. Mention two sources of demand for foreign exchange? i)Import of goods and services ii) To send gifts abroad.

11. i) 12.

Mention two sources of supply of foreign exchange? Export of goods and services ii) Foreign direct investment Define balance of payment on capital account?

It consists of transactions in financial assets in the form of short term and long term lending and borrowings and private and government investments.

3 /4 mark questions. 1. Differentiate between balance of trade and balance of payment? Meaning: Balance of trade is the value of goods (visible item)imported and exported. Balance of

i)

payment includes visible as well as invisible items.

ii)

Nature: Balance of trade is narrow concept and it is a components of BOP. Balance of payment is

wider concept.

iii)

Significance: BOT is not real indicator of economic transaction. BOP is the true indicator of economic

transcation between the countries.

iv)
2. i) ii) iii) 3.

Balanced: BOT can be favourable or unfavourable, but BOP is always balance. Mention the components of current account? Export and import of goods Export and import of services Unilateral payments Mention the components of capital account?

(i) Private transactions : (ii) Official transactions : (iii) Direct investment : (iv) Portfolio investment 4. Explain the function of foreign exchange market? Transfer Function : it transfers the purchasing power between countries. Credit Function : It provides credit channels for foreign trade.

Hedging Function: It protects against foreign exchange risks.

5.

Mention the merits and de-merits of foreign exchange rate? Merits: i) promotes world trade and economic stability ii) capital movement De-merits: No cost price relationship

6.

Mention the merits and de-merits of flexible exchange rate? Merits: Promotes economic development and cooperation, optimum utilization of resources De-merits: It encourages speculation and wider fluctuation

6 mark question. 1. Explain the determination of foreign exchange rate. Use diagram. Determination of Rate of Foreign Exchange In a system of flexible exchange rate, the exchange rate of a currency is determined by forces of demand and supply of foreign exchange. Expressed graphically, the intersection of demand and the supply curves determines the equilibrium exchange rate and equilibrium quantity of foreign currency. Sources of Demand for Foreign Exchange. The following factors cause demand for foreign exchange. (a) To purchase goods and services by domestic residents from foreign countries. (b) To purchase financial assets. (c) To send gifts and grants abroad. (d) To undertake foreign tours etc. There is inverse relationship between price of foreign exchange and demand for foreign exchange. That is why demand curve for foreign exchange becomes downward sloping. Sources of Supply of Foreign Exchange (i) When foreigners purchase home countrys goods and services through exports. (ii) When foreigners invest in bonds and equity shares of the home country.

(iii) When Indian workers working abroad send their savings to families in India. (iv) When foreign tourists come to India. There is a direct relationship between price of foreign exchange and supply of foreign exchange. That is why supply curve is upward rising. Equilibrium Exchange Rate: This is determined at a point where demand for and supply of foreign exchange is equal. Graphically, intersection of demand and supply curves determines the equilibrium exchange rate of foreign currency.

PREPARED BY P.RAMESH KUMAR PGT (ECO) JNV UNA (H.P)