- Exchange rate systems: Flexible, Fixed, and Managed Floating.
- Flexible (floating) rate is determined by demand and supply of foreign exchange.
- Increase in forex demand → depreciation; increase in forex supply → appreciation.
- Speculation, interest rates, and income levels affect exchange rates.
- In fixed exchange rate, government intervenes; devaluation (rate ↑) and revaluation (rate ↓).
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."
Formulae [1]
Balance of Trade (BoT)
BoT = Vx - Vm
Where Vx = Value of goods exported
Vm = Value of goods imported.
Key Points
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: Determination of the Exchange Rate
Key Points: Merits and Demerits of Flexible and Fixed Exchange Rate Systems
- Fixed exchange rate: Requires large foreign exchange reserves and is prone to speculative attacks.
- Fixed system demerit: BoP deficits force government intervention and possible devaluation.
- Flexible exchange rate: Adjusts automatically to BoP surpluses and deficits.
- Flexible system merit: No need for large reserves and greater monetary policy independence.
Key Points: Current Account
- Current Account records trade in goods, services, and transfer payments.
- Includes exports & imports, factor/non-factor services, and transfers (gifts, remittances).
- Surplus: receipts > payments; Deficit: receipts < payments.
- Two parts: Balance of Trade (goods) and Net Invisibles (services & transfers).
- Exports increase and imports reduce domestic demand.
Key Points: Capital Account
- Capital Account records international asset transactions.
- Purchase of foreign assets = debit; sale to foreigners = credit.
- Includes FDI, FII, external borrowings, assistance.
- Surplus: capital inflows > outflows.
- Deficit: capital inflows < outflows.
