- 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."
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: 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 rate = price of one currency in terms of another.
- Demand for forex arises due to imports, gifts, and foreign investments.
- Higher forex price → imports fall → demand for forex falls.
- Supply of forex comes from exports, transfers, and foreign investment.
- Higher forex price → exports rise → supply of forex increases.
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
- It is a mix of fixed and flexible exchange rate systems.
- Exchange rate is mainly decided by market forces, but the central bank intervenes when needed.
- Also called dirty floating.
- Central bank uses foreign exchange reserves to limit excessive fluctuations.
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
