- Systematic Record: Records all receipts and payments with foreign countries.
- Fixed Period: Prepared for a specific period, usually one year.
- Comprehensive: Includes visible, invisible and capital transactions.
- Double Entry System: Every transaction is recorded as both receipt and payment, making it self-balancing.
Definitions [2]
Definitions: Balance of Payments
- According to Kindleberger, "The balance of payments of a country is a systematic record of all economic transactions between its residents and residents of foreign countries."
- According to Sodersten, "The Balance of Payments is merely a way of listing receipts and payments in international transactions for a country."
- According to James O. Ingram, "The Balance of Payments is a summary record of all economic transactions between residents of one country and the rest of the world during a given period of time."
- According to Walter Krause, “The balance of payments of a country is a systematic record of all economic transactions completed between its residents and the rest of the world during a given period of time usually a concept of year."
- The government of every country keeps account of its economic transactions with other countries of the world. The record of economic transactions among different countries is known as balance of payments.
Definitions: Exchange Rate
- According to Anatol Murad, “The ratio at which one country's currency can be exchanged for another is the rate of exchange between these two currencies.”
- According to Haines, “Exchange rate is the price of one currency stated in terms of another currency.”
- According to Sayers, “The prices of currencies in terms of each other are called foreign exchange rate.”
- According to Crowther, “The rate of exchange measures number of units of one currency which is exchanged in the foreign market for one unit of another.”
Key Points
Key Points: Concept of Balance of Payments
- BoP is a systematic record of all economic transactions between a country's residents and the rest of the world over one year.
- It covers visible items (goods), invisible items (services and transfers), and capital transactions.
- The two main accounts are the Current Account and the Capital Account.
- BoP follows the double-entry bookkeeping system, so Total Credits = Total Debits.
- A Current Account Deficit is generally financed through capital inflows or borrowing from abroad and may increase a country's external debt burden if it persists.
Key Points: Features of Balance of Payment
Key Points: Balance of Trade and Balance of Payments- Comparison
| Basis | Balance of Trade (BOT) | Balance of Payments (BOP) |
|---|---|---|
| Meaning | Deals only with exports and imports of visible goods | Includes all international transactions |
| Coverage | Goods only | Goods, services, income, transfers & capital flows |
| Scope | Narrow concept | Broader concept |
| Relationship | Part of Balance of Payments | Includes Balance of Trade |
| Balance Position | Can be favourable, unfavourable or balanced | Always balanced (double-entry accounting) |
Key Points: Structure of Balance of Payment
- Credit Side: Receipts from abroad (exports, income, capital inflow).
- Debit Side: Payments made to foreign countries (imports, expenses, capital outflow).
- Current Account: Records export–import of goods (visible) and services (invisible).
- Capital Account & Overall BOP: Capital account balances deficits/surpluses; total BOP always balances.
Key Points: Methods to Measure Balance of Payments
- Basic Balance:
Current account balance + long-term capital balance. - Net Liquidity Balance:
Basic balance + short-term illiquid capital + SDRs + errors and omissions. - Official Settlement Balance:
Net liquidity balance + short-term private liquid capital. - These methods show how external deficits or surpluses are finally settled.
Key Points: Components of Balance of Payments
- Two sides:
Credit (receipts) = money received from abroad,
Debit (payments) = money paid to foreigners. - Current Account:
Includes exports & imports of goods (visible), services (invisible), income, and gifts/transfers. - Capital Account:
Includes foreign loans, investments, banking capital, gold, SDRs, and reserve changes. - Meaning:
BOP shows the flow of receipts and payments with other countries over a period, not assets and liabilities.
Key Points: Current Account Transactions
- Export & Import of Goods (Visible Trade):
Export of goods earns foreign exchange (credit); import of goods uses foreign exchange (debit). - Services (Invisible):
Includes shipping, banking, insurance, tourism, etc.
Export of services = credit; import of services = debit. - Unilateral Transfers:
Gifts, donations, remittances, aid received = credit;
gifts and aid given to other countries = debit. - Income:
Investment income (interest, dividends, profits) and wages.
Income received from abroad = credit; paid to foreigners = debit.
Key Points: Capital Account Transactions
- Meaning:
Capital account shows international movement of capital (loans, investments, assets). - Credit items:
Borrowing from abroad, foreign investment in the country, increase in foreign reserves. - Debit items:
Lending or investing abroad, repayment of foreign loans, buying foreign assets. - Key point:
Current account affects income, while capital account affects assets and liabilities.
Key Points: Balance of Payments Always Balances
- Accounting sense:
Balance of Payments always balances due to the double entry system (total credits = total debits). - Operational (economic) sense:
Current account surplus or deficit is adjusted through the capital account. - Key adjustment:
Deficit in current account = surplus in capital account, and vice-versa. - Conclusion:
Overall Balance of Payments is always zero, though individual accounts may show imbalance.
Key Points: Categories of Balance of Payments
- Balance of Trade:
Difference between exports and imports of visible goods only. - Balance of Current Account:
Includes goods, services (invisibles) and transfers; shows flow of income. - Balance of Capital Account:
Records capital inflows and outflows like loans, investments, gold, forex. - Balance of Payments:
Sum of current account + capital account; always balances in accounting sense. - Key relation:
Current account deficit is matched by capital account surplus, and vice versa.
Key Points: Balance of Payments Disequilibrium
- Disequilibrium occurs when receipts and payments are unequal, resulting in surplus or deficit.
- Fall in Exports / Rise in Imports:
Due to fall in foreign demand, inflation at home, or appreciation of currency. - Development & Cost Factors:
High developmental imports, rising production costs, or supply shortages reduce export competitiveness. - Other Causes:
Debt burden, population growth, demonstration effect, and political instability worsen BOP position.
Key Points: Measures to Correct Adverse Balance of Payments
- Exchange Rate Measures:
Depreciation or devaluation makes exports cheaper and imports costlier, improving BOP. - Trade Measures:
Import control (tariffs, quotas) reduces imports, while export promotion increases foreign earnings. - Economic Policies:
Tight monetary and fiscal policies reduce excess spending and imports. - Other Measures:
Import substitution, exchange control, and capital inflow (IMF loans, SDRs, foreign investment) help cover deficits.
Key Points: Foreign Exchange Rate
- Foreign exchange refers to foreign currency used for international payments.
- The foreign exchange market is the market (system) where foreign currencies are bought and sold.
- Exchange rate is the price of one currency in terms of another currency (e.g., 1 USD = ₹75).
- Demand for foreign exchange arises from imports, gifts and transfers abroad, loan repayments, investment abroad, purchase of foreign financial assets, and outbound tourism.
- Supply of foreign exchange arises from exports, FDI and portfolio investment, remittances, loans from abroad, gifts and transfers received, and inbound tourism.
- A rise in the exchange rate generally reduces demand for foreign exchange and may increase its supply by encouraging exports.
- The exchange rate is determined by the demand for and supply of foreign exchange in the foreign exchange market.
Key Points: Types of Foreign Exchange Rate
- Fixed Exchange Rate System:
The exchange rate is fixed by the government or central bank and does not change freely. - Flexible Exchange Rate System:
The exchange rate is determined by market forces of demand and supply of foreign currency. - Key Difference:
Fixed rates ensure stability, while flexible rates adjust automatically to economic changes. - Economist Link:
Robert Mundell explained how monetary and fiscal policies work under fixed and flexible exchange rates.
Key Points: Fixed Rate of Exchange
- The exchange rate is officially fixed by the central bank/government and does not change with market demand and supply.
- The central bank buys and sells foreign currency to maintain the fixed rate, using foreign exchange reserves.
- It provides certainty and stability, which promotes international trade and investment.
- However, it reduces monetary independence and requires large foreign exchange reserves.
Key Points: Flexible Rate of Exchange
- Exchange rate is decided by demand and supply of foreign exchange.
- Also called floating exchange rate; government does not fix the rate.
- Allows automatic balance of payments adjustment.
- Causes uncertainty and speculation in the economy.
Key Points: Managed Floating Exchange Rate System
- Managed floating = hybrid of fixed + flexible exchange rate systems.
- Also called "dirty floating".
- Exchange rates are mainly driven by market forces.
- Central bank intervenes to moderate fluctuations.
- Official reserve transactions are not zero.
- Central banks maintain reserves to influence rates.
- The current global regime operates under this system.
Key Points: Determination of Equilibrium Rate of Exchange
- Fixed Exchange Rate: Determined by the government/central bank, earlier based on gold content of currencies.
- Flexible Exchange Rate: Determined by demand and supply of foreign exchange in the market.
- Demand for foreign exchange comes from imports, foreign payments, loans, etc. (inverse relation with exchange rate).
- Supply of foreign exchange comes from exports and foreign capital (direct relation with exchange rate).
- Equilibrium rate is where demand equals supply of foreign exchange.
Key Points: Factors or Determinants of Foreign Exchange Rate
- Trade conditions: More exports → currency strengthens; more imports → currency weakens.
- Capital movements: Foreign investment inflow raises demand for home currency.
- Bank rate: Higher bank rate attracts foreign capital and strengthens currency.
- Inflation: Higher inflation reduces currency value in foreign markets.
- Government policies: Exchange control and protection affect demand for foreign currency.
- Political stability: Peace and security attract foreign capital and strengthen currency.
Key Points: Concepts of Depreciation, Appreciation, Devaluation and Revaluation
- Depreciation: Fall in value of domestic currency under flexible exchange rate (e.g. ₹75 → ₹80 per $).
- Appreciation: Rise in value of domestic currency under flexible exchange rate (e.g. ₹75 → ₹70 per $).
- Devaluation: Official reduction in value of currency under fixed exchange rate system.
- Revaluation: Official increase in value of currency under fixed exchange rate system.
- Effect on Trade (in one line):
Depreciation/Devaluation → imports ↓, exports ↑
Appreciation/Revaluation → imports ↑, exports ↓
Key Points: Determination of Exchange Rate in a Free Market
-
Exchange rate is determined by demand and supply of foreign exchange (e.g. dollars) in the foreign exchange market.
-
Demand for foreign exchange arises from imports, foreign investment, gifts, remittances abroad; it falls when exchange rate rises (downward-sloping demand curve).
-
Supply of foreign exchange comes from exports, foreign investment inflows, tourism, remittances; it rises when exchange rate rises (upward-sloping supply curve).
-
Equilibrium exchange rate is fixed at the point where demand equals supply of foreign exchange.
-
Automatic adjustment:
BOP deficit → excess demand for foreign currency → currency depreciates → imports ↓, exports ↑
BOP surplus → excess supply of foreign currency → currency appreciates → imports ↑, exports ↓
Concepts [22]
- Concept of Balance of Payments
- Features of Balance of Payment
- Balance of Trade and Balance of Payments- Comparison
- Structure of Balance of Payment
- Methods to Measure Balance of Payments
- Components of Balance of Payments
- Current Account Transactions
- Capital Account Transactions
- Balance of Payments Always Balances
- Categories of Balance of Payments
- Balance of Payments Disequilibrium
- Measures to Correct Disequilibrium in the Balance of Payments
- Foreign Exchange Rate
- Exchange Rate
- Types of Foreign Exchange Rate
- Fixed Rate of Exchange
- Flexible Rate of Exchange
- Managed Floating Exchange Rate System
- Determination of Equilibrium Rate of Exchange
- Factors or Determinants of Foreign Exchange Rate
- Concepts of Depreciation, Appreciation, Devaluation and Revaluation
- Determination of Exchange Rate in a Free Market
