Balance of Payments (BOP) and Foreign Exchange

Balance of Payments (BOP)

• A comprehensive and systematic record of all economic transactions between normal residents of a country and the rest of the world during an accounting year.
• Accounts of Balance of Payments include:
  • Current Account
    • Records export and import of goods and services and unilateral transfers.
    • Components of Current Account:
      • Export and Import of Goods (Merchandise Transactions or Visible Trade)
        • Major part of transactions in foreign trade is in the form of export and import of goods.
        • Payment for import of goods is written on the negative side (debit items) and receipt from exports is shown on the positive side (credit items).
      • Export and Import of Services (Invisible Trade)
        • Includes a large variety of non-factor services sold and purchased by residents of a country, to and from the rest of the world.
        • Payments are either received or made to other countries for use of these services.
      • Unilateral or Unrequited Transfers to and from abroad (One sided Transactions)
        • Unilateral transfers include gifts, donations, personal remittances, and other ‘one-way’ transactions.
        • These refer to those receipts and payments, which take place without any service in return.
      • Income receipts and payments to and from abroad
        • Includes investment income in the form of interest, rent, and profits.

Flexible Exchange Rate

• Merits:
  • No need to hold foreign exchange reserves
  • Leads to automatic adjustment in the balance of payments
  • Enhances efficiency in resources allocation
  • Removes obstacles in the transfer of capital and trade
  • Eliminates the problem of undervaluation or overvaluation of currency
  • Promotes venture capital in the form of foreign exchange
• Demerits:
  • Fluctuations in future exchange rate
  • Encourages speculation
  • Discourages international trade and investment
  • Creates a situation of market instability
  • Demand for foreign exchange has an inverse relation with flexible exchange rate
  • Supply of foreign exchange has a positive relation with foreign exchange rate

Managed Floating System

• Under a managed float, market forces determine exchange rates until they move too far in one direction or another
• The government then intervenes to maintain the currency within the broad range considered appropriate
• Advantage: has the market-response nature of a freely floating system while allowing for government intervention when necessary
• Dominant exchange rate system in use among the world’s largest economies is the managed float system

Exchange Rates and Purchasing Power

• The graph depicts the relationship between the supply of, and demand for, a foreign currency by consumers and investors who use a given domestic currency
• Demand curve for the foreign currency is downward sloping
• Supply curve for the foreign currency is upward sloping
• As investors sell this currency, more of it is available, which is reflected in a rightward shift of the supply curve
• A new equilibrium point is at a lower price in terms of investors’ domestic currencies

Financial Factors that Affect Exchange Rates

• Relative Interest Rates:
  • When the interest rates in a foreign country rise relative to those of a domestic country, more investors are willing to buy the foreign country’s currency to make investments and the demand for the foreign currency rises
  • This rightward shift of the demand curve results because holders of other currencies seek the higher returns available in the foreign country
  • As more investors buy the high-interest country’s currency to make investments, less of it is available, which is reflected in a leftward shift of the supply curve
  • A new equilibrium point is at a higher price in terms of investors’ domestic currencies
• Ease of Capital Flow:
  • If a country with high real interest rates removes restrictions on the cross-border movement of capital, the demand for the currency and the currency’s value rises as investors seek higher returns
  • This factor has become by far the most important of those listed

Comprehensive records of economic transactions between a country and the rest of the world during an accounting year, including current account and its components