Definitions [1]
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.
Formulae [4]
Formula: Interest Rate Differential
\[\text{Interest Rate Differential}=i_A-i_B\]
Formula: Exchange Rate
\[\text{Exchange Rate (PPP)}=\frac{\text{Domestic Price}}{\text{Foreign Price}}\]
Formula: Balance of Payment
Current Account + Capital Account = 0
Balance of Trade (BoT)
BoT = Vx - Vm
Where,
Vx = Value of goods exported
Vm = Value of goods imported
BoT Surplus:
\[V_x>V_m\]
BoT Deficit:
\[V_m>V_x\]
Key Points
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: Determination of the Exchange Rate
- Exchange rate = Price of one unit of foreign currency in terms of domestic currency.
- Flexible exchange rate is determined by Demand = Supply.
- Increase in demand for foreign currency → Depreciation of domestic currency.
- Decrease in demand for foreign currency → Appreciation of domestic currency.
- Main determinants: Speculation, Interest Rate Differential, Income Changes, PPP.
- Fixed exchange rate is maintained by Government/RBI through buying or selling foreign exchange.
- Depreciation/Appreciation occur under a Flexible system.
- Devaluation/Revaluation occur under a Fixed system.
Key Points: Merits and Demerits of Flexible and Fixed Exchange Rate Systems
| Feature | Fixed | Flexible |
|---|---|---|
| BoP Adjustment | Manual / government-managed | Automatic |
| Monetary Policy Independence | Limited | Preserved |
| Speculation Risk | Lower (but vulnerable to attacks) | Higher |
| Reserves Required | Large reserves needed | Not required |
| Stability | High | Lower |
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: Current Account
- The current account records transactions in goods, services, factor income, and unilateral transfers.
- Goods are the visible component; services, factor income, and transfers are invisible components.
- IMF's BPM6 classifies BOP into Current, Capital, and Financial Accounts. India has adopted this classification, but the RBI continues to publish data according to the old classification.
- Current Account Surplus → Country is a net lender; Current Account Deficit → Country is a net borrower.
- Balance of Trade covers only goods; Balance on Invisibles covers services, factor income, and transfers.
- Exports and receipts are Credits (+); Imports and payments are Debits (−).
Key Points: Capital Account
- The Capital Account records international transactions involving assets (money, stocks, bonds, government debt).
- Purchases of assets are debits; sales of assets are credits in terms of foreign exchange flows.
- The account can show a surplus, deficit, or balance depending on the direction of capital flows.
- The main components are FDI, FII (Portfolio Investment), external borrowings, and external assistance.
- Capital inflows are recorded as Credit (+) entries; capital outflows are recorded as Debit (−) entries.
Key Points: Balance of Payments Surplus and Deficit
- BoP always balances: Current Account + Capital Account ≡ 0.
- Autonomous transactions are independent ("above the line"); accommodating transactions finance the BoP imbalance ("below the line").
- Accommodating items include IMF borrowings and changes in foreign exchange reserves.
- BoP surplus = Autonomous receipts > Autonomous payments; BoP deficit = Autonomous payments > Autonomous receipts.
- Errors and Omissions is a separate third element of the BoP.
- BoT covers goods only; BoP covers goods, services, transfers, and capital transactions.
- IMF's BPM6 classifies the BoP into Current, Financial, and Capital Accounts; the RBI continues to publish data according to the old classification as well.
