<h5 id="61-the-balance-of-payments">6.1 The Balance of Payments</h5> <ul> <li>The balance of payments (BoP) is a record of transactions between a country’s residents and the rest of the world for a specific time period, typically a year.</li> <li>The two main accounts in the BoP are the current account and the capital account.</li> <li>The current account records transactions in goods, services, and income.</li> <li>The capital account records transactions in assets and liabilities.</li> <li>The sum of the current account and the capital account equals the overall balance of payments.</li> </ul> <p>======</p> <h5 id="611-current-account">6.1.1 Current Account</h5> <ul> <li>Current Account Surplus, Balanced Current Account, and Current Account Deficit are three states of a country’s current account.</li> <li>Current Account Surplus exists when Receipts (Exports of goods and services) are greater than Payments (Imports of goods and services).</li> <li>Balanced Current Account occurs when Receipts (Exports of goods and services) are equal to Payments (Imports of goods and services).</li> <li>Current Account Deficit exists when Receipts (Exports of goods and services) are less than Payments (Imports of goods and services).</li> <li>Balance on Current Account has two components: Balance of Trade (BOT) and Net Invisibles.</li> <li>BOT is the difference between the value of exports and imports of goods, while Net Invisibles is the difference between the value of exports and imports of invisibles (services, transfers, and flows of income).</li> </ul> <p>======</p> <h5 id="612-capital-account">6.1.2 Capital Account</h5> <ul> <li>Capital account records international transactions of assets.</li> <li>Asset forms include money, stocks, bonds, and Government debt.</li> <li>Purchase of assets is a debit item, sale of assets is a credit item.</li> <li>Items included in capital account transactions are Foreign Direct Investments (FDIs), Foreign Institutional Investments (FIIs), external borrowings and assistance.</li> <li>Capital account is in balance when inflows equal outflows, surplus arises with greater inflows, deficit arises with lesser inflows.</li> </ul> <p>======</p> <h5 id="613-balance-of-payments-surplus-and-deficit">6.1.3 Balance of Payments Surplus and Deficit</h5> <ul> <li>The text provides a summary of a country’s trade balance and balance of payments.</li> <li>The Trade Balance (goods only) is -904, with Exports at 1502 and Imports at 2403.</li> <li>The Current Account Balance is -386, which is the sum of the Trade Balance and Net Invisibles (52), which includes Non-factor Services (30), Income (-10), and Transfers (325).</li> <li>The Capital Account Balance is 41.15, which includes External Assistance (0.15), External Commercial Borrowings (2), Short-term Debt (10), Banking Capital (net) (15), Foreign Investments (net) (19), and Other Flows (net) (-57).</li> <li>The Overall Balance, which is the sum of the Current Account Balance, Capital Account Balance, and Errors and Omissions, is 9. The Reserves Change is 0.</li> </ul> <p>======</p> <h5 id="62-the-foreign-exchange-market">6.2 The Foreign Exchange Market</h5> <ul> <li>The foreign exchange market is where national currencies are traded for one another.</li> <li>It is a global market with major participants being commercial banks, foreign exchange brokers, other authorized dealers, and monetary authorities.</li> <li>The price at which currencies are traded is called the exchange rate.</li> <li>This market is crucial for individuals or entities involved in international transactions, such as an Indian resident visiting London, who needs pounds for her stay.</li> <li>Although participants may have their own trading centers, the market is worldwide with close and continuous contact between trading centers.</li> </ul> <p>======</p> <h5 id="621-foreign-exchange-rate">6.2.1 Foreign Exchange Rate</h5> <ul> <li>Foreign Exchange Rate is the price of one currency in terms of another.</li> <li>Demand for foreign exchange is driven by the desire to purchase goods and services from other countries, send gifts abroad, and buy financial assets of a certain country.</li> <li>An increase in the price of foreign exchange increases the cost of foreign goods, reducing demand for imports and hence demand for foreign exchange.</li> <li>Supply of foreign exchange is influenced by exports, gifts or transfers from foreigners, and purchase of home country’s assets by foreigners.</li> <li>An increase in the price of foreign exchange reduces the cost of purchasing products from the home country, potentially increasing exports and supply of foreign exchange.</li> </ul> <p>======</p> <h5 id="622-determination-of-the-exchange-rate">6.2.2 Determination of the Exchange Rate</h5> <ul> <li>The exchange rate can be determined by market forces of demand and supply (Flexible/Floating Exchange Rate), fixed by the government (Fixed Exchange Rate), or managed while allowing some flexibility (Managed Floating Exchange Rate).</li> <li>In a Flexible Exchange Rate system, the exchange rate is determined where the demand curve intersects with the supply curve. An increase in demand for foreign goods and services results in the appreciation of the domestic currency, while a decrease in demand leads to depreciation.</li> <li>Speculation can affect exchange rates as investors buy or sell foreign currency based on expectations of future value changes. This can create self-fulfilling prophecies in exchange rates.</li> <li>Interest rate differentials and investor behavior can influence exchange rates in the short run. A higher interest rate in one country relative to another can lead to an appreciation of the currency with the higher interest rate.</li> <li>Income levels, consumer spending, and import/export prices can impact exchange rates over time. The Purchasing Power Parity (PPP) theory suggests that exchange rates should eventually adjust to reflect differences in price levels between countries.</li> </ul> <p>======</p> <h5 id="623-merits-and-demerits-of-flexible-and-fixed-exchange-rate-systems">6.2.3 Merits and Demerits of Flexible and Fixed Exchange Rate Systems</h5> <ul> <li>In a fixed exchange rate system, the government maintains the value of its currency in relation to another currency or a basket of currencies.</li> <li>The main challenge for fixed exchange rates is maintaining credibility, as governments must have adequate foreign exchange reserves to intervene and maintain the specified rate during balance of payment (BoP) deficits.</li> <li>A lack of confidence in the government’s ability to maintain the fixed rate can lead to speculative attacks, where aggressive buying of the currency forces devaluation.</li> <li>Flexible exchange rates provide governments more flexibility, as they don’t need to maintain large foreign exchange reserves or intervene to maintain the exchange rate.</li> <li>The major advantage of flexible exchange rates is that they automatically adjust for BoP surpluses and deficits, and allow countries to independently conduct their monetary policies.</li> </ul> <p>======</p> <h5 id="624-managed-floating">6.2.4 Managed Floating</h5> <ul> <li>The world has largely adopted a managed floating exchange rate system.</li> <li>This system is a mix of flexible and fixed rate systems, also known as “dirty floating”.</li> <li>Central banks intervene in buying and selling foreign currencies to moderate exchange rate movements.</li> <li>Official reserve transactions are not equal to zero under this system.</li> <li>Intervention occurs when central banks feel it is appropriate to moderate exchange rate movements.</li> </ul> <p>======</p> <h5 id="key-concept">Key Concept</h5> <ul> <li>The text is about Open Economy and Balance of Payments, focusing on the Current Account Deficit and Official Reserve Transactions.</li> <li>It explains the concepts of Autonomous and Accommodating Transactions, and Nominal and Real Exchange Rates.</li> <li>The text discusses Purchasing Power Parity, Flexible and Fixed Exchange Rates, and Depreciation.</li> <li>It also mentions the Interest Rate Differential, Managed Floating, Demand for Domestic Goods, Marginal Propensity to Import, Net Exports, and Open Economy Multiplier.</li> <li>The text further includes the concept of Devaluation.</li> </ul> <p>======</p>