Balance of Payments

     

                                                            Balance of Payments                                

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 nation’s 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 country’s 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

Foreign Exchange means foreign currency.

Foreign Exchange Rate : The rate at which currency of one country can be exchanged for currency of another country is called the rate of Foreign Exchange.

Nominal Vs Real Exchange Rate

Nominal echange rate is price of foreign currency in terms of domestic currency.  Real exchange rate is the relative price of foreign goods in terms of domestic goods.

Foreign Exchange Market : The market in which national currencies of various countries are

converted,exchanged or traded for one another is called foreign exchange market.

Spot Market : If the operation is of daily nature, it is called spot market or current market.  The

exchange rate that prevails in the  spot market for foreign exchange is called Spot Rate.

Forward Market :  A market in which foreign exchange is bought and sold for future delivery is

known as forward market.  Exchange rate that prevails in a forward contract for purchase or sale of foreign exchange is called Forward Rate.

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 country’s 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 are equal.  Graphically, intersection of demand and supply curves determine the equilibrium exchange rate of foreign currency.

                     

                                                        

Quantity of US dollars

Fixed Exchange Rate System : Fixed exchange rate is the rate which is officially fixed by the

govt. or monetary authority and not determined by market forces.

Flexible (Floating) Exchange Rate System : The system in which rate of exchange is determined by forces of demand and supply in foreign exchange market.

NEER : Nominal Effective Exchange Rate : It is the measure of average relative strength of a given currency with respect to other currencies without eliminating the effect of price change.

REER: Real Effective Exchange Rate : It calculates an effective exchange rate based on real

exchange rate instead of nominal rate.

RER : Real Exchange Rate : It is the exchange rate which is based on constant prices to eliminate the effect of price changes.

Parity Value : In a fixed exchange rate system, the value of currency is fixed in terms of another

currency or in terms of gold.  This is known as parity value of currency.