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.
FOREIGNEXCHANGERATE

MeaningAndDetermination.
Meaning:Foreignexchangerateisthepriceofonecurrencyistermsofanother.
ForeignExchangeMarket:Theforeignexchangemarketisthemarketwherethenationalcurrenciesaretradedforone
another.
FunctionofForeignExchangemarket:
1.

Transferfunction

2.

Creditfunction

3.

Hedgingfunction.

1) TransferFunction:ittransfersthepurchasingpowerbetweencountries.
2) CreditFunction:Itprovidescreditchannelsforforeigntrade.
3) HedgingFunction:Itprotectsagainstforeignexchangerisks.

DEMANDANDSUPPLYFORFOREIGNEXCHANGE

DEMANDFORFOREIGNEXCHANGE
Itisthedemandforforeigncurrenciesbytheresidentsofacountry.Transactionsintheforeignexchangemarketare
reflectedinthebalanceofpaymentsaccount.
1) DEMANDSIDE:Peopledesiretohaveforeignexchangeforthefollowingreasons:
(i)

Topurchasegoodsandservicesfromothercountries.

(ii)

Tosendgiftsabroad.

(iii)

Topurchasefinancialassets.

(iv)

Tospeculateonthevalueofforeigncurrencies.

2) SUPPLYSIDE;Foreigncurrencies,flowintothedomesticeconomyduetothefollowingreasons.
(i)

Foreignerspurchasinghavecountrysgoodsandservicesthroughexports.

(ii)

Foreigninvestmentinhomecountry.

(iii)

Foreigncurrenciesflowintotheeconomyduetocurrencydealersandspeculators.

EQUILIBRIUMINTHEFORIGNEXCHANGEMARKET
Foreignexchangemarketlikeanyothernormalmarketcontainsadownwardslopingdemandcurveandanupward
slopingsupplycurve.Thepriceisshownontheverticalaxisandthehorizontalaxismeasuresthequantitydemandedor

supplied.Theintersectionofthesupplyanddemandcurvedeterminestheequilibriumexchangerate(Reg)andthe
equilibriumquantity(Qeg)offoreigncurrencyi.e.US($)
S$
D$

Price
R1
Of $
Equi
(in

Price
Rs)
R2

Equi.Q

DemandandSupplyOfUS$

TYPESOFEXCHANCERATE
FixedExchangeRateSystems:Underthissystemexchangerateisofficiallydeclaredanditisfixedonlyaverysmall
deviationfromthisfixedvalueispossible.
AtypicalfixedexchangeratesystemwasassociatedwiththeGoldStandardSystemsof18801914.underthis
systemsvalueofcurrencywasfixedintermsofGold.
For:Re

50,

125gmGold

25gmgold

Re

5$

FLEXIBLEEXCHANGERATESYSTEM:

FlexibleexchangeratespointtoanextremesituationwherethereisnointerventionbyCentralBanks.The
foreignexchangemarketisbusyatalltimesbychangesintheexchangerates.

ADVANTAGEOFFLEXIBLEEXCHANGERATESYSTEM
(i)

Flexibleexchangerateseliminatetheneedforecentralbankstoholdinternationalreserves.

(ii)

Helpfultodoawaywithbarriertotrade.

(iii)

Enhancestheefficiencyintheeconomy.

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

MANAGEDFLOATING:
The final hybrid inmanagement of fixed and flexible exchange ratesis themanaged floating. The intervention is
discretionaryonthepartofmonetaryauthorities.

OPERATIONOFFOREIGNEXCHANGEMARKET
OperationofForeignexchangemarketareoftwotypes:1)Currentmarketforthespotmarket.
2)Forwardmarket.

1)SPOTMARKETFORFOREIGNEXCHANGE:
Spotrateofforeignexchangeisusefulforcurrenttransactions.Itisalsoimportanttofindthestrengthofthedomestic
currency.ThemeasureofaveragerelativestrengthofagivencurrencyiscalledtheeffectiveexchangeRate(EER).
Aswedonotclimatetheeffectofpricechanges,thismayalsobecalledasNominaleffectiveExchangeRate
(NEER).
Andwhenweeliminatetheeffectofpricechanges,thisisrealexchangerate(RER)Realeffectiveexchange
Rates(REER)isbasedonrealexchangerates.
AnotherofthespotrateisPurchasingPowerParity(PPP).Therearetwoversionsofit:

1) Absolutepurchasingpowerparity.
2) Relativepurchasingpowerparity.
1) AbsolutePurchasingpowerparity:Itconsideredthesamepriceofcommodityinthewholeworld.
2) Relativepurchasingpowerparity:Itconsideredtheratesofinflationinthetwocountries.
3) ForwardMarketforforeignexchange:Theforwardmarketforforeignexchangecoverstransactionswhich
occur at a future date. Most of the international transaction does not occur on same day. Usually they
materiablisemuchlater.
Aforwardcontractisenteredintofortworeasons:1)Tominimizeriskofloss.
2)Tomakeaprofit
Anyproblemwiththeexchangeratecouldcreateenormousdifficultiesnotonlyforthecountryconcernedbut
toothersaswell.
1markquestions.
1.

Whatismeantbybalanceoftrade?
Balanceoftradereferstothedifferenceinthevalueofimportsandexportsofvisibleitems.

2.

Definebalanceofpayments.
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.

Nametwoinvisibleitemsofcurrentaccountofbalanceofpayments.
Bankingandshippinginsurance.

4.

Definebalanceofpaymentoncurrentaccount?
Itreferstoallreceiptsandpaymenttransactionsrelatingtotradeingoods,servicesandunilateraltransfers.

5.

Isbalanceofpaymentalwaysbalanced?
Balanceoftradecanbefavourableorunfavourablebutbalanceofpaymentisalwaysbalanced.

6.

Defineforeignexchangerate?
Foreignexchangerateisthepriceofonecurrencyistermsofanother

7.

Whatisfixedexchangerate?

Itisasysteminwhichexchangetransactionstakeplaceataratefixedbymonetaryauthorities.
8.

Whatisflexibleexchangerate?
Itisasysteminwhichthevalueofonecurrencyintermsofanotherisfreelydeterminedbydemandand
supplyofforeignexchange.

9.

Defineforeignexchangemarket?
Themarketatwhichdifferentcurrenciesareexchangedwithoneanother.

10. Mentiontwosourcesofdemandforforeignexchange?
i)Importofgoodsandservicesii)Tosendgiftsabroad.

11. Mentiontwosourcesofsupplyofforeignexchange?
i)

Exportofgoodsandservicesii)Foreigndirectinvestment

12. Definebalanceofpaymentoncapitalaccount?
Itconsistsoftransactionsinfinancialassetsintheformofshorttermandlongtermlendingandborrowings
andprivateandgovernmentinvestments.

3/4markquestions.
1.

Differentiatebetweenbalanceoftradeandbalanceofpayment?
i)

Meaning: Balance of trade is the value of goods (visible item)imported and exported.
Balanceofpaymentincludesvisibleaswellasinvisibleitems.

ii)

Nature: Balance oftradeisnarrowconcept and it isa componentsofBOP.Balance of

paymentiswiderconcept.

iii)

Significance:BOTisnotrealindicatorofeconomictransaction.BOPisthetrueindicatorof
economictranscationbetweenthecountries.

iv)
2.

Balanced:BOTcanbefavourableorunfavourable,butBOPisalwaysbalance.

Mentionthecomponentsofcurrentaccount?

3.

i)

Exportandimportofgoods

ii)

Exportandimportofservices

iii)

Unilateralpayments

Mentionthecomponentsofcapitalaccount?

(i) Private transactions :

(ii) Official transactions :
(iii) Direct investment :
(iv) Portfolio investment
4.

Explainthefunctionofforeignexchangemarket?
TransferFunction:ittransfersthepurchasingpowerbetweencountries.
CreditFunction:Itprovidescreditchannelsforforeigntrade.
HedgingFunction:Itprotectsagainstforeignexchangerisks.

5.

Mentionthemeritsanddemeritsofforeignexchangerate?
Merits:i)promotesworldtradeandeconomicstabilityii)capitalmovement
Demerits:Nocostpricerelationship

6.

Mentionthemeritsanddemeritsofflexibleexchangerate?
Merits:Promoteseconomicdevelopmentandcooperation,optimumutilizationofresources
Demerits:Itencouragesspeculationandwiderfluctuation

6markquestion.
1.

Explainthedeterminationofforeignexchangerate.Usediagram.
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.

PREPAREDBYP.RAMESHKUMARPGT(ECO)JNVUNA(H.P)