Balance of Payments (BOP) and Foreign Exchange
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Questions and Answers

What happens to the supply curve of a currency when investors sell it?

  • It shifts to the right. (correct)
  • It shifts to the left.
  • It becomes vertical.
  • It remains unchanged.

    • What is the result of higher inflation in a foreign country on the domestic currency?

  • It remains unchanged.
  • It depreciates in relation to the foreign currency.
  • It appreciates in relation to the foreign currency. (correct)
  • It becomes fixed.

    • What is the relationship between the difference in inflation rates and the change in exchange rate?

  • The difference in inflation rates is half the change in exchange rate.
  • The difference in inflation rates is twice the change in exchange rate.
  • The difference in inflation rates approximately equals the change in exchange rate. (correct)
  • The difference in inflation rates is equal to the change in exchange rate.

    • What happens to the demand for foreign currencies when persons with higher incomes look for new consumption opportunities in other countries?

    <p>It increases.</p> Signup and view all the answers

    What is the effect of trade barriers on the domestic currency?

    <p>It appreciates.</p> Signup and view all the answers

    What is the effect of currency controls on exchange rate volatility?

    <p>It decreases.</p> Signup and view all the answers

    What happens to the prices of foreign currencies when domestic incomes rise?

    <p>They increase.</p> Signup and view all the answers

    What is the effect of government intervention on the process of exchange rate determination?

    <p>It complicates the process.</p> Signup and view all the answers

    What is a key advantage of a flexible exchange rate system?

    <p>It leads to automatic adjustment in the balance of payments.</p> Signup and view all the answers

    What is a demerit of a flexible exchange rate system?

    <p>It leads to fluctuations in future exchange rates.</p> Signup and view all the answers

    What is a source of demand for foreign exchange?

    <p>To undertake foreign tours.</p> Signup and view all the answers

    What is the relationship between the demand for foreign exchange and the flexible exchange rate?

    <p>They have a negative relationship.</p> Signup and view all the answers

    What is a source of supply of foreign exchange?

    <p>Direct investment by foreigners in the domestic market.</p> Signup and view all the answers

    What is the relationship between the supply of foreign exchange and the flexible exchange rate?

    <p>They have a positive relationship.</p> Signup and view all the answers

    What is a merit of a flexible exchange rate system?

    <p>It eliminates the problem of undervaluation or overvaluation of currency.</p> Signup and view all the answers

    What is a disadvantage of a fixed exchange rate system?

    <p>It discourages the objective of having free markets.</p> Signup and view all the answers

    What happens to the domestic currency when more people purchase it?

    <p>It appreciates against the foreign currency</p> Signup and view all the answers

    What is the effect of an expansionary monetary policy on the exchange rate when the effects are not fully anticipated?

    <p>It decreases the exchange rate</p> Signup and view all the answers

    What is the effect of a restrictive monetary policy on the exchange rate when the effects are not fully anticipated?

    <p>It increases the exchange rate</p> Signup and view all the answers

    What is the general effect of an expansionary fiscal policy on the exchange rate?

    <p>It leads to currency appreciation</p> Signup and view all the answers

    What happens to the demand curve for a foreign currency when interest rates in that country rise relative to those of a domestic country?

    <p>It shifts to the right</p> Signup and view all the answers

    What happens to the supply curve of a foreign currency when investors buy more of it to make investments?

    <p>It shifts to the left</p> Signup and view all the answers

    What is the effect of removing restrictions on the cross-border movement of capital in a country with high real interest rates?

    <p>The demand for the currency increases</p> Signup and view all the answers

    What is the relative importance of the ease of capital flow compared to other financial factors that affect exchange rates?

    <p>It is the most important factor</p> Signup and view all the answers

    What is the primary purpose of the Balance of Payments?

    <p>To maintain a comprehensive record of all economic transactions between a country and the rest of the world</p> Signup and view all the answers

    What is the term used to describe the balance of visible exports and imports?

    <p>Balance of Trade</p> Signup and view all the answers

    What type of services are included in the invisible trade?

    <p>Shipping, Banking, and Insurance</p> Signup and view all the answers

    What happens to the price of the Indian rupee when it appreciates?

    <p>It decreases</p> Signup and view all the answers

    What is the effect of the appreciation of the domestic currency on imports?

    <p>It increases imports</p> Signup and view all the answers

    What are unilateral transfers?

    <p>One-way transactions without any service in return</p> Signup and view all the answers

    What is included in the income receipts and payments to and from abroad?

    <p>Interest, Rent, and Profits</p> Signup and view all the answers

    What is the characteristic of a managed float exchange rate system?

    <p>The market forces determine the exchange rate until they move too far in one direction or another, and then the government intervenes</p> Signup and view all the answers

    What is the shape of the demand curve for a foreign currency?

    <p>Downward sloping</p> Signup and view all the answers

    Which of the following is a component of the Current Account?

    <p>Export and Import of Goods</p> Signup and view all the answers

    What is the purpose of recording payments for import of goods in the Balance of Payments?

    <p>To show the payment as a debit item</p> Signup and view all the answers

    What happens to goods and services denominated in the domestic currency when the foreign currency becomes more expensive?

    <p>They become less expensive</p> Signup and view all the answers

    Why are receipts from exports of goods shown on the positive side of the Balance of Payments?

    <p>Because they are a source of income for the country</p> Signup and view all the answers

    What is the advantage of a managed float exchange rate system?

    <p>It has the market-response nature of a freely floating system while allowing for government intervention when necessary</p> Signup and view all the answers

    What is the shape of the supply curve for a foreign currency?

    <p>Upward sloping</p> Signup and view all the answers

    Which exchange rate system is dominant among the world's largest economies?

    <p>Managed float exchange rate system</p> Signup and view all the answers

    Study Notes

    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

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    BOP PDF

    Description

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

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