Unit : 5

What Are Balance Of Payments ?

Balance Of Payment

It is a systematic record of the transactions between the residents of the country and the residents of the rest of the world.

Items that are covered under Balance of Payment

  • Exports and imports of goods
  • Exports and imports of the services
  • Unilateral transfers like gifts and donations
  • Foreign loans
  • Foreign investment and grants

Components of Balance of Payment

Current Account

The current account of balance of payment records the value of exports and imports of goods, value of exports and imports of services and the unilateral transfers.

  • Export and Import of visible items
  • Export and Import of invisible items
  • Unilateral transfer
  • Income receipt and payments from and to abroad

Capital Account

The capital account records all the transactions between the residents of a country and the residents of the rest of the world which results in to the change in ownership of assets.

  • Foreign Investments
  • Borrowings
  • Official International Reserves

BOP (Deficit)

Balance of Payment is in deficit when the total payments of foreign exchange are in excess of the total receipts. This results in the net outflow of foreign exchange and a decrease in the official reserves of foreign exchange.

Balance of Payment Transactions

  • Autonomous Items

It refers to such balance of payment transactions which are undertaken for their own sake.

  • Accommodating Items

This is also known as below the line items and these transactions are undertaken to correct the disequilibrium in the balance of payment accounts.

Foreign Exchange Rate

It refers to the quantity of domestic money which is exchanged for one unit of foreign currency. In another way, it can be said that it is the amount of foreign currency which one unit of domestic currency can buy.

Type of Exchange Rate

  • Fixed Exchange Rate

The rate of exchange is determined by the government. It has two variants. One is known as gold standard system of exchange rate and another one is Bretton Woods system of exchange rate or the adjustable peg system of exchange rate.

  • Flexible Exchange Rate

The exchange rate between two currencies is determined by the demand and supply of the currencies under consideration. Under this system, the equilibrium rate of exchange is determined at that price and quantity of foreign exchange at which demand of foreign currency is equal to its supply.

  • Managed / Dirty Floating

It is a variant of flexible exchange rate system in which the determination of the foreign exchange is not entirely left into the hands of market forces of demand and supply of foreign exchange. Rather, under this system the central bank of the country intervenes from time to time to manage the exchange rate so that it remains within the pre-determined manageable limits. It is also known as dirty floating.

Foreign Exchange Market

It refers to the mechanism which facilitates the determination of exchange rate in the economy.

Types of Foreign Exchange Market

  • Spot Market
  • Forward Market

Determination Of Foreign Exchange Rate

  • Demand for foreign currency depends upon the quantity of imports, foreign investment abroad, repayment of international loans, grants and donations, payment of factor incomes etc.
  • Supply of foreign exchange depends upon the exports, inflow of foreign investment, repayment of loans, grants and donations inflow, remittances from abroad etc.
  • Foreign exchange rate is determined by demand and supply of foreign exchange.

Managed Floating Exchange Rate System

It is a mixture of a flexible exchange rate system (the float part) and a fixed exchange rate system (the managed part). The exchange rate is given a specific target and a central bank keeps the rate from not deviating too far from a target value.