Balance of Payments and

Exchange Rates
BIJU P M PGT ECONOMICS KV NO II KOCHI
“The balance of payments of a country is a
systematic record of all economic transactions
between its residents & residents of foreign
countries.”
It is determined considering all economic transactions, viz. visible items, invisible
items, capital transfers. Therefore balance of payment offers a more comprehensive
picture of economic transactions of a country with rest of the world.
 Economic transaction in balance of payment are broadly categorized as:

All types of
All types of It includes which are
services –
physical goods bankng,insurance,travel
concerned with capital
exported/imported. services,cosultancy services receipts & capital
investment income- interest, payments. Involve the
profit, dividend &royalties transfer of assets.
unilateral transfers- Gifts,
Donations etc.
Mainly two accounts-current
& Capital
 BoP and BoT
• BoP is a comprehensive record of a country’s
visible and invisible exports and imports
• BoT includes only visible transactions and is a
part of BoP
• BoP always balances whereas BoT can be
deficit or surplus
Current account is that account which records imports & exports
of goods and services and the unilateral Transfer (Gifts, financial
aid, donations etc.).

Current A/C transactions

bring about a change in the
current level of country’s
income whereas
capital transaction bring
about a change in the
capital stock of a country.

Current A/C transactions

are of flow nature. Whereas
capital transaction are
generally of stock nature.
 UK balance of payments: 2001 (£ millions)
Example :
1 . Components /items of Current Account
UK balance of payments: 2001 (£ millions)
 The BOPs of a country includes five major accounts. They are -

Debits (-) Credits (+) Debits (-) Credits (+)

A. Imports of A. Exports of
goods goods
B. Imports of B. Exports of
services services Debits (-) Credits (+)

Debits (-) Credits (+)

A. Unilateral A. Unilateral Debits (-) Credits (+)
transfers(gif transfers(gifts)
ts)made received
CAUSES OF DISEQUILIBRIUM: Disequilibrium in BOP is caused by a
number of factors, broadly categorized as (a) economic factors (b) political
factors (c) social factors. Following are the details:
DISEQUILIBRIUM IN
BOP
 Some of the effects of unfavourable BOP are as follow :

1. It lowers economic credibility of a country –

2. It hampers economic development of a country –

3. It reduces foreign exchange reserves of a country –

4. It leads to exploitation of a country -

1. More demand for consumption goods:
2. Imports of machinery and equipment :
3. Imports of war equipment :
4. Setting up of embassies :
5. Hike in the petrol prices :
6. Increase in foreign competition :
 Demand for Foreign exchange comes from
a) domestic resident to purchase goods and services from other
countries
b) for sending gifts to foreigners
(c) by the domestic residents to purchase financial assets in a
particular country
d) Speculation purpose: Speculative trading

Supply of Foreign exchange comes from

a) the foreigner’s purchasing home currency goods and services through exports
b) the foreigners who invest in home country through joint ventures
c) foreign currencies flow into the economy due to currency dealers and speculators

Equilibrium exchange rate is determined at a point where the demand for and
supply of foreign exchange are equal
Refers to rate of exchange as fixed by the government. Historically it has two important
variants :
(a) Gold standard system of exchange rate :
(b) Bretton Woods system of exchange rate:
OR
Adjustable peg system of exchange rate
(a) Gold standard system of exchange rate:
According to this system of exchange rate – Gold was taken as the
common unit of parity between currencies of different countries in
circulation . (prevalent in most countries prior to 1920)

Each country was to define value of its currency in terms of gold

Example : If UK 1 (pound = 4 grams of gold ;
or 1 US Dollar = 02 grams of gold
(b) : Bretton Woods system of exchange rate :
It introduced in 1944 even when it was a fixed system of exchange rate,
allowed some adjustments. So,it was called adjustable peg system of
exchange rate.
According to this system –
(i) The dollar was made directly convertible into gold at fixed
price.
(ii) The member countries were required to fix the parity of
their currency with gold .
(iii) Adjustment in the parity was possible only through a direction
of IMF
:
:
II. Flexible Exchange Rate :
:
 III. Managed floating :

In managed floating system, there is official declaration of rules or guidelines

for intervention, no prefixed parity values and no announced times for
variations. Authority intervenes if a particular situation in their judgment
requires it.

In dirty floating , a particular country manipulates its managed float to the

disadvantage of other countries.

Dirty floating is related to the managed floating system of exchange rate . In this
system, the central bank intervenes to buy & sell foreign currencies in an attempt to
moderate exchange rate movements whenever they fear that such actions are
required.
 The rate is determined in the foreign exchange market by the interaction of the
demand for and supply of foreign exchange currencies.
Equilibrium exchange rate occurs when supply of and demand for foreign
exchange are equal to each other or intersection of both demand and supply
curve determines the equilibrium rate of exchange.

Y D s
R1 __ _ _ __ _ _ _ _ _ _
* E *
Rate of exchange

__________

__________

R OR = Equilibrium rate of exchange

R2 _ _ _ _ _ _ *_ _ _ _ _ _ * OQ =Equilibrium quantity
If the rate of exchange rises OR1 then supply
s D of foreign currency (ON) will exceed its
demand(OM) by an amount equivalent to MN.
O M Q N X If the rate of exchange falls to OR2 then
demand for foreign currency (ON) will be more
Demand & supply than supply (OM).
(foreign currency
 Let us consider the case for Indian Rupee & US Dollar.

(i) An increase in the demand for

foreign exchange
D1
Y D s
DD : The initial demand curve for US
R1 __ _ _ __ _ _ _ _ _ _E dollar
Price(Rs/dollar)

E
__________

D1 D1 : A forward shift in demand curve

R for
US dollar.
D1 Consequently, price of a US dollar rises
s D from
OR to OR1 . It is a situation of a rise in
O Q Q1 X exchange rate ,dollar is appreciating while
Rupee is depreciating.
Demand & supply
(US Dollar )
 Let us consider the case for Indian Rupee & US Dollar.

(i) An increase in the supply for foreign

exchange
D s
Y S1
SS : The initial supply curve for US dollar
R S1 S1 : A forward shift in supply curve for
Price(Rs/dollar)

R1 US dollar.
Consequently, price of a US dollar
decreases from OR to OR1 . It is a situation
s D of a fall in
exchange rate ,dollar is depreciating.
S1 while
O Q Q1 X Rupee is appreciating
Demand & supply
(US Dollar )
Trading ,imports and exports requires a place or market.So foreign exchange market
is the market, where national currencies are traded for foreign currency.
It is the centre of trade (such as Bank & brokers –they make transaction in foreign
exchange)for different currencies.

Note : Availability of foreign

exchange depends upon its
demand & supply.
Foreign exchange markets operates either – as
(a)Spot Market :(current account)
(b) Forwarded Market :such transactions of foreign

exchange as are meant for future delivery.

Such transaction are signed today, but are to
materialize on some future date.
Currency Depreciation(exchange depreciation) takes place when there is an
increase in the domestic currency price of the foreign country. In this situation,
domestic currency( or home currency) is less valuable.
Currency Appreciation – (Exchange appreciation) takes place where there is a
decrease in the domestic currency price of the foreign currency. In this case domestic
currency is more valuable.
BIJU P M PGT ECO KV II
KOCHI