SANJAY - THE INSTITUTE OF HUMANITIES

9990291091

Class - Xll
Subject - Economics
Notes - Balance of Payment

Introduction

An open economy interacts with other countries through various

channels, unlike a closed economy with no external linkages. It trades
goods, services, and financial assets internationally, fostering
economic growth and global integration.
Three main ways in which these linkages are established in an open
economy:
1. Output Market: Involves trade in goods and services between
countries, providing consumers and producers with a wider range of
choices.
2. Financial Market: Allows investors to buy financial assets from
other countries, expanding investment opportunities beyond domestic
borders.
3. Labour Market: Enables firms to choose production locations and
workers to choose employment destinations, although immigration
laws may restrict labor movement.
Foreign trade affects Indian aggregate demand in two ways: imports
decrease it (leakage), while exports increase it (injection).

● Foreign economic agents require stable purchasing power in

a national currency.

● Confidence in stability is crucial for acceptance as an

international medium of exchange.

● Lack of stability undermines trust, hindering usage as a unit of

account in global transactions.

● Governments historically promised national currency

convertibility into fixed assets.

● Typically, assets included gold or other currencies.

● Issuing authorities relinquished control over the asset's value.

● Credibility relied on unrestricted conversion and fixed

conversion rates.

● The international monetary system regulated these aspects

for stability in global transactions.

 ● Increased transaction volumes led to the decline of gold as

the asset backing national currency convertibility.

● While some national currencies have international

acceptance, the currency used in transactions between

countries is crucial.

● The chosen currency for trade transactions holds significance,

regardless of the international acceptability of individual

currencies.

The Balance of Payments

Meaning: The balance of payments of a country is a systematic record of all

economic transactions between residents of a country and residents of foreign

countries during a given period of time.

There are two main accounts in BoP - the current account and the
capital account
Current Account: The current account is a record of a country's trade
in goods and services, along with transfer payments. It includes
exports, imports, and various payments and receipts, such as
remittances and grants, without expecting goods or services in return.
 Components of Current Account
Balance on Current Account
When the receipts and payments on the current account are equal,
the current account is balanced. A surplus indicates that the nation
lends to other countries, while a deficit suggests that the nation
borrows from them.
Balance on Current Account has two components:
● Balance of Trade: A balanced Balance of Trade (BOT)

occurs when a country's exports of goods equal its imports. A

surplus BOT arises when exports exceed imports, while a

deficit occurs when imports exceed exports. Net Invisibles

represent the difference between a country's exports and

imports of services, transfers, and income flows. These include

factor income from production factors and non-factor income

 from service products like shipping, banking, and tourism. It is

also known as Trade Balance.

● Balance of Payments: The balance on invisibles refers to the

net difference between the value of exports and imports of

services, transfers, and income flows between countries. It

includes factor income earned from production factors (like

labor and capital) and non-factor income from service

products (such as shipping and tourism). A positive balance

indicates that a country earns more from its invisible

transactions than it spends, while a negative balance suggests

the opposite.

Capital Account: The Capital Account records all international

transactions involving assets, which can include money, stocks,
bonds, and government debt. Purchases of assets are debits on the
capital account, such as when an Indian buys a UK car company,
resulting in foreign exchange flowing out of India. Conversely, sales of
assets, like selling shares of an Indian company to a Chinese
customer, are credits on the capital account. Capital account
transactions include Foreign Direct Investments (FDIs), Foreign
Institutional Investments (FIIs), external borrowings, and assistance.
The following table shows components of capital account
Balance on Capital Account
The Capital Account is balanced when capital inflows (e.g., loans,
asset sales) equal outflows (e.g., loan repayments, asset purchases).
A surplus occurs when inflows exceed outflows, while a deficit arises
when outflows surpass inflows.
Balance of Payments Surplus and Deficit
The essence of international payments resembles an individual's
budgeting: if a country has a current account deficit (spending
exceeds income), it must finance it by selling assets or borrowing
abroad. Thus, a deficit is balanced by a capital account surplus,
representing a net inflow of capital. In balance of payments
equilibrium, the deficit is fully financed by international borrowing,
without using reserves.
● Foreign exchange reserves: Assets held to stabilize currency

and meet international obligations, safeguarding economic

stability.
 ● Balance of payments deficits: Occur when expenditures

exceed revenues, necessitating intervention to maintain stability.

● Official reserve sales: Central bank's selling of foreign

exchange reserves to counterbalance deficits and stabilize

currency.

● Official reserve transactions: All transactions except those in

this category may be termed as autonomous transactions. They

are so called because they were entered into with some

independent motive. Balance of payments always balance.

Autonomous and Accommodating Items

● Autonomous items: Autonomous items in the B.O.P refer to

international economic transactions that take place due to

some economic motive such as profit maximization. These

items are often called above the line items in the B.O.P.

The balance of payments is in a deficit if the autonomous

receipts are less than autonomous payments. The monetary

authorities may finance a deficit by depleting their reserves of

foreign currencies, or by borrowing from I.M.F.

● Accommodating items: Accommodating items in the B.O.P.

refer to transactions that occur because of other activity with

 the B.O.P such as government financing. Accommodating

items are also referred to as below the line of items.

Errors and Omissions: In the Balance of Payments (BoP),

alongside the current and capital accounts, there's a third component
known as "errors and omissions." This element accounts for
inaccuracies in recording international transactions. Following table
illustrates a sample BoP for India, highlighting a trade deficit and
current account deficit, yet a capital account surplus.

Sample of Balance of Payments for India

The Foreign Exchange Market

● Our exploration of international transactions now narrows to

focus on a single transaction scenario.
● Understanding the exchange rate becomes crucial as it
determines the price of currencies in the foreign exchange
market.
● Major participants in this market include commercial banks,
foreign exchange brokers, authorized dealers, and monetary
authorities.
● Despite these entities potentially operating from their own trading
centers, it's essential to recognize that the foreign exchange
market operates globally.
 ● This global operation facilitates trading across multiple locations,
with seamless communication between trading centers enabling
participants to engage in transactions across various markets.
Foreign Exchange Rate
● Foreign Exchange refers to all currencies other than the

domestic currency of a given country.

● Foreign exchange rate is the rate at which currency of one

country can be exchanged for currency of another country.

● Foreign Exchange Market: The Foreign Exchange market is

the market where the national currencies are traded for one

another.

● Functions of Foreign Exchange Market:

● Transfer function: It transfers the purchasing power

between countries.

● Credit function: It provides credit channels for foreign

trade

● Hedging function: It protects against foreign exchange

risks.
Demand For and Supply of Foreign Exchange
Demand for Foreign Exchange
● To purchase goods and services from other countries

● To send gifts abroad

● To purchase financial assets (shares and bonds)

● To speculate on the value of foreign currencies

● To undertake foreign tours

● To invest directly in shops, factories, buildings

● To make payments of international trade.

Supply of foreign exchange:

Foreign currencies flow into the domestic economy due to the
following reason.
● When foreigners purchase home countries goods and services

through exports
 ● When foreigners invest in bonds and equity shares of the

home country.

● Foreign currencies flow into the economy due to currency

dealers and speculators.

● When foreign tourists come to India

● When Indian workers working abroad send their saving to

families in India.

Determination of the Exchange Market

Different countries adopt different methods to determine their

currency's exchange rate based on their economic policies and goals:
● Flexible Exchange Rate: Determined by market demand,

supply. Value fluctuates freely, no government, central bank

intervention. Market forces set currency value, leading to daily

fluctuations.

● Fixed Exchange Rate: Currency value tied to another

currency, commodity. Government, central bank intervene to

maintain fixed value, buying, selling currency reserves.

● Managed Floating Exchange Rate: Hybrid system, currency

fluctuates within range. Government, central bank intervene to

influence exchange rate if deviates too much.

Flexible Exchange Rate

● Flexible exchange rates determined by market forces

● Demand and supply intersection sets rates

● Increased demand for foreign goods shifts demand curve

● Higher demand leads to currency depreciation

● Depreciation means more domestic currency needed for one

unit of foreign currency

● Appreciation occurs when domestic currency strengthens

● Appreciation means fewer units of domestic currency needed

for one unit of foreign currency

When demand for foreign goods and services rises, like due to
increased international travel among Indians, the exchange rate shifts.
Initially at 50 Rupees per Dollar (e0), it rises to 70 Rupees per Dollar
at the new equilibrium (e1). This means Rupees have depreciated
against Dollars, costing more Rupees for each Dollar.
Below is the graph of Equilibrium Under Flexible Exchange Rate
In a flexible exchange rate system, if the price of the domestic

currency (Rupees) increases relative to the foreign currency

(Dollars), it's termed Appreciation. This signifies that Rupees gain

value against Dollars, requiring fewer Rupees for each Dollar in

exchange.

Effect of an
Increase in Demand for Imports in the Foreign Exchange Market
Speculation

Money held in any country is considered an asset. If Indians predict

the British pound will strengthen against the Rupee, they'll aim to

obtain pounds. This impacts exchange rates, driven by individuals

holding foreign currency in anticipation of appreciation. This

expectation influences rates directly. For instance, if the current rate is

80 Rupees per pound and investors expect it to rise to 85 Rupees,

they might invest 80,000 Rupees for 1000 pounds, anticipating a profit

Interest Rates and the Exchange Rate

In the short term, interest rate differentials between countries impact
exchange rates. Funds from banks, corporations, and individuals flow
globally to seek higher interest rates. For instance, if Country A
offers 8% interest on government bonds and Country B offers 10%,
investors from A will buy B's currency, depreciating A's currency and
appreciating B's. Domestic interest rate hikes often lead to currency
appreciation, assuming no restrictions on foreign bond purchases.

Income and the Exchange Rate

● Increased income boosts consumer spending and imports.

● Higher imports shift demand curve for foreign exchange

rightward, depreciating domestic currency.

● Increased foreign income raises domestic exports, shifting

foreign exchange supply curve outward.

● Currency depreciation hinges on whether exports outpace

imports; faster domestic demand growth typically leads to

depreciation.

Exchange Rates in the Long Run

● Purchasing Power Parity (PPP) theory predicts long-run

exchange rates in flexible systems.

● Assumes no trade barriers like tariffs or quotas.

● Exchange rates adjust so identical products cost the same

regardless of currency (e.g., a product costs the same whether

measured in rupees in India, dollars in the US, yen in Japan).

 ● Long-term rates reflect differences in price levels between

countries.

Exchange Rate
Fixed Exchange Rates
● In fixed exchange rate systems, government fixes exchange

rate (e.g., Rs 70 per dollar instead of Rs 50).

● Higher rate leads to excess dollar supply, requiring RBI

intervention to purchase them (e.g., intervention at rate e1).

● Conversely, lower rate like e2 leads to excess dollar demand,

risking a black market for dollars.

● Increasing rate is Devaluation, decreasing is Revaluation (e.g.,

making domestic currency cheaper or costlier).

 Foreign Exchange Market with Fixed Exchange Rates
Merits and Demerits of Flexible and Fixed Exchange Rate Systems
● Fixed exchange rate system requires government credibility to

maintain specified rate.

● Deficits in BoP may prompt government intervention using

reserves.

● Insufficient reserves may lead to doubts and speculation,

potentially triggering devaluation.

● Speculative attacks on currency can occur if doubts lead to

aggressive buying.

● Flexible exchange rate system offers government more

autonomy, requiring fewer foreign exchange reserves.

● Advantages include automatic adjustment of surpluses and

deficits in BoP.
 ● Countries gain independence in conducting monetary policies

due to minimal intervention needs.

Managed Floating: This is the combination of fixed and flexible

exchange rate. Under this, country manipulates the exchange rate to
adjust the deficit in the B.O.P by following certain guidelines issued by
I.M.F.
Dirty floating: If the countries manipulate the exchange rate without
following the guidelines issued by the I.M.F is called as dirty floating.

Determination of Equilibrium Income in Open Economy

Given the choice to purchase goods from both local and international
sources, it's crucial to differentiate between overall demand for goods
and specifically for those produced domestically by consumers and
firms.
National Income Identity for an Open Economy
In a closed economy, three sources drive demand for domestic goods:
consumption (C), government spending (G), and domestic investment
(I)
We can write
Y = C+ I+ G
In an open economy, exports (X) increase demand for domestic goods
and services from abroad, while imports (M) add to the supply of
foreign goods domestically. Thus, the national income identity must
include both exports and imports.
Y+M=C+I+G+X
On rearranging we get
Y=C+I+G+X–M
or
Y = C + I + G + NX
Where NX represents net exports (exports - imports). A positive NX,
indicating exports surpassing imports, signifies a trade surplus.
Conversely, a negative NX, indicating imports exceeding exports,
denotes a trade deficit.
To analyze how imports and exports influence equilibrium income in
an open economy, we follow the same process as in a closed
economy, treating investment and government spending as
autonomous. Additionally, we must specify the factors influencing
imports and exports. Import demand is influenced by domestic income
(Y) and the real exchange rate (R). Increased income results in higher
imports.
● Real exchange rate (R) compares foreign goods' price to

domestic goods'.

● Higher R makes foreign goods relatively more expensive,

decreasing imports.

● Imports increase with domestic income (Y) but decrease with

R.

● Exports are essentially the imports of other countries.

● Our exports depend on foreign income (Yf) and R.

● Higher Yf boosts foreign demand for our goods, increasing

exports.

● A higher R, making domestic goods cheaper, also boosts

exports.

● Exports depend on foreign income and the real exchange rate.

 ● Assuming constant price levels and nominal exchange rates, R

remains fixed.

● From our country's perspective, foreign income and exports

are exogenous (X = Xmean ).

● Import demand depends on income and has an autonomous

component.

The marginal propensity to import (MPI) represents the fraction of an

additional rupee of income spent on imports, similar to the concept of
the marginal propensity to consume (MPC).