Introductory Macroeconomics Chapter 6 Open Economy Macroeconomics

Meaning of Balance of Payments Account (BOP Account). A balance of payment account is a systematic record of all economic transactions between residents of a country and the residents of foreign countries during a given period of time. BOP Account records a country’s all transactions with the rest of the world involving inflow and outflow of foreign exchange. Thus BOP Account is basically a flow of foreign exchange account.
Simply put, BOP account is a statement of country's sources and uses of foreign exchange in which main (i) sources are: exports, transfers and remittances from abroad, borrowings from abroad, foreign investments and (ii) uses are: imports, transfers to abroad, lending abroad and purchase of assets etc.
BOP account, like a typical business account, is based on double entry system which contains two sides, namely, Credit side and Debit side. Any transaction which brings in foreign exchange (currency) is recorded on credit side whereas any transaction that causes a country to lose foreign exchange is recorded on debit side. For example export is a credit item as it brings in foreign exchange whereas import is a debit item since it causes outflow of foreign exchange. Similarly borrowing from rest of world (ROW) is a credit item while lending to ROW is a debit item

The various items which make up country’s Balance of Payments Account are listed in a simplified consolidated form in the above table. They are explained as under:
1.    Export and import of goods (Merchandise). The most straight forward way in which a country can acquire foreign currency is by exporting goods. These are called visible items because goods can be seen, touched and measured. This is shown by row (1) which indicates that the country has exported goods to a value of र 550 crores. In an analogous (similar) way, row (5) shows that the country has imported goods to a value of र 800 crores. These two rows describe the country's visible trade. Movement of goods between countries is known as visible trade because the movement is open and can be verified by custom officials at custom barriers.
2.    Services rendered and received. It includes both (a) non-factor income like income from shipping, banking, insurance, tourism, software services, and (b) factor income (investment income) like interest, dividends, profits on assets abroad. It should be noted that interest, dividends and profits, which citizens of a country earn on investment abroad are investment income and treated as factor income. Citizens of the country own land, bonds, shares, etc. abroad for which the foreigners who enjoy the services of this capital will have to pay for them. These payments will be registered under row (2) exports of services or invisible exports.
In a completely analogous way, row (6) covers payments which residents of the country in question make to foreigners for similar services. All these items describe country's invisible trade.
Balance of Invisibles. The balance of imports and export of services is called balance of invisibles since services are not seen to cross national borders. The invisible account includes (i) services like insurance, banking etc. (ii) investment income like rent, dividend and (iii) unilateral transfers like gifts, donations.

3.    Unilateral transfers. (Gifts, remittances, donations, indemnities, etc. from foreigners). The items in row (3) are called unrequited receipts because residents of a country receive ‘for free’. Nothing has to be paid in return at present or future for these receipts. These are like transfer payments. It includes both private and government transfers. Examples of this head are gifts received by residents from foreigners, remittances sent by emigrants (like Indians in Gulf Countries) to relatives, war indemnities paid by a defeated country, etc.
Note: In India unrequited or unilateral transfers are treated as a part of invisible trade.
Remember, sum total of the above-mentioned three components (merchandise, services and transfers) is called BOP on current account whereas the following 4th component comprises BOP on capital account.
4. Capital receipts and payments. (Borrowings, investment, capital repayments, sale of assets, changes in foreign exchange reserves). It records international transactions which affect the assets and liabilities of domestic country with ROW. Items (4) and (8) of the table given above, indicate changes in stock magnitudes and refer to capital receipts and payments. Government of a country may borrow (get loan) from another government; a firm may issue stocks abroad or a bank may float a loan in a foreign country. In all these instances, the country in question will acquire foreign currency and these transactions will be entered as credit items in row (4). Similarly, foreigners may acquire assets in the country with whose balance of payments they are concerned. Assets may be in the form of land, houses, plants, shares, etc. Changes in stock of gold or reserves of foreign currency are also included in Row (4). Analogously, if residents of the country in their turn were to acquire similar foreign assets, this would give rise to outflow of foreign currency and come as a capital transfer recorded as debit item in row (8).

Balance of Trade. It is the difference between the money value of exports and imports of material goods (called visible items) during a year. Clearly, the two transactions which determine BOT are exports of goods and import of goods (visible items). Examples of visible items are clothes, shoes, machines etc. The difference between the values of exports and imports of goods is called balance of trade or trade balance. Exports are considered as income and imports as an expenditure. It includes exchange of only visible items and does not consider exchange of services (i.e., invisible trade). Alternatively, balance of visible items is called balance of trade.
Surplus or deficit BOT. Balance of trade may be in surplus or in deficit or in equilibrium. If value of exports of visible items is more than the value of imports of visible items, balance of trade shows a surplus. Then BOT is also called positive or favourable. In case value of exports is less than the value of imports, the balance of trade is said to be negative or adverse or unfavourable, Thus, the balance of trade is called in deficit. In case value of exports equals its imports, the balance of trade is said to be balanced or in equilibrium. Remember when balance of trade is in deficit, it is offset with the help of capital account. 

BOT = Value of exports – Value of imports
        = 250 – 200 = 50 crores

BOT = Value of exports – Value of imports
–60 = Value of export – 100
Value of export = 100 – 60 = 40 crores.

Balance of Payments account. BOP account of a country is systematic record of all economic transactions between residents of the domestic country and the residents of foreign countries during a given period of time. It is a complete statement of a country’s receipts and payments in foreign exchange arising from international transactions.
•    BOP account records a country's transactions in goods, services and assets with rest of the world during a given period.
•    BOP is the difference between a nation's total payment of foreign exchange to foreign countries and its total receipts from them.
•    Borrowing from abroad is a part of capital account of BOP account as it is a foreign liability.

Comparison between BOT and BOP. Briefly BOT is the difference between money value of imports and exports of material goods only whereas BOP is the difference between a country's receipts and payments in foreign exchange. Balance of payments is a wider concept as compared to balance of trade because BOT is just one of the four components of the former. BOT includes only export and import of goods whereas BOP includes (i) export and import of goods (ii) export/import of services (iii) unilateral receipts/payments and (iv) capital receipts/payments. Therefore, BOP represents wider and comprehensive picture of a country's economic transactions with the rest of the world than the Balance of Trade. Both are compared below.

The current account of BOP account is that account which records imports and exports of goods, services and unilateral transfers during a year. It relates to all activities which do not alter the value of assets and liabilities of a country. Current account deals with real and short term transactions. These are called actual transactions as they affect income, output and employment of a country through transfer of goods and services. Thus balance of current account can be estimated as the sum total of balance of trade, balance of services and balance of unilateral transfers.
Components of current account of BOP. These items are as under:
(i)    Export and import of goods (called visible trade),
(ii)   Export and import of services – non-factor and factor services (called invisible trade),
(iii)  Unilateral transfers (Transfer receipts/payments) and
(iv)  Investment income (factor income from land, bonds, shares abroad).
The following extract from RBI's quarterly bulletin further clarifies the components of current account of Balance of Payment. The item ‘Merchandise’ used in the table means goods and their exports recorded as credits and imports as debits.

Source: Reserve Bank of India bulletin, May 2011.

Capital Account. The capital account of BOP records all such transactions which relate to purchase and sale of foreign assets and foreign liabilities during a year. It shows all the inflows and outflows of capital. It represents international flow of loans and investments which cause a change in country's foreign assets and liabilities. Capital account flows consist of foreign investments, foreign loans, commercial borrowings, banking capital, etc.
Components of capital account. Main forms of capital account transactions are given below:
(i)    Foreign investment. This refers to investment to and from Rest of World. Investment may be direct or portfolio. Direct investment means purchasing an asset and acquiring control of the same e.g. purchase of a house abroad. As against it portfolio investment means acquisition of asset that does not give control over asset, e.g. purchase of a bond issued by a foreign government.
(ii)    Foreign loans. These refer to credit granted by foreign governments and international institutions like IMF. External commercial borrowing are also included.
(iii)    Banking capital and other capital. Banking capital includes inflow and outflow of banking capital (non-residints deposits) excluding the central bank.
(iv)    Monetary movements or changes in foreign exchange reserve. This reserve keeps on changing depending upon the net balance of other private and official transactions.
The following extract from RBI's quarterly bulletin clearly shows the components of capital account of Balance of Payment.

Source: Reserve Bank of India bulletin, May 2011.

Mind, the sum of current account and capital account should be zero. A deficit (or surplus) on current account is always matched by an equal surplus (or deficit) in capital account. 

True/False. The statement is false because export and import of all goods including machines are recorded in current account.
Note: There is third category (besides current account and capital account) called official reserve account which records transactions of central bank in BOP statement. These transactions are called accommodating or ‘beloiv the line’ transactions. It relates to running down of its reserves of foreign exchange by selling foreign currency in foreign exchange market in case of deficit. The decrease (or increase) in official reserves is called the overall balance of payments deficit (or surplus).

Economists distinguish between autonomous and accommodating items used in BOP. The basic difference between the two is that whereas deficit or surplus in BOP occurs due to autonomous items, the accommodating items are taken to maintain balance in BOP account.
(a)    Autonomous items in BOP. These refer to international economic transactions that take place due to some economic motives like profit maximisation. Such transactions are independent of the state of country's balance of payments i.e. irrespective of whether BOP is favourable or unfavourable. These items are generally called ‘above the line items’ in BOP. Again it is autonomous transactions which make deficit or surplus in BOP. BOP is in deficit if the autonomous receipts are less than autonomous payments. BOP is in surplus if the autonomous receipts are greater than autonomous payments. In other words, deficit or surplus in BOP occurs due to autonomous items (As against it, accommodating items are meant to restore equilibrium). Mind, when total inflow (of foreign exchange) on account of autonomous transactions is less than total outflow on account of such transactions, there is deficit in BOP account.
(b)    Accommodating items in BOP. These refer to transactions that take place to cover deficit or surplus in the autonomous transactions. In other words accommodating items are taken to maintain balance in BOP account. These items are also called ‘below the line items’. Because of government financing, official settlement, are seen as accommodating items to keep the BOP identity. The official settlement approach is based on the assumption that monetary authority is the ultimate financier of any deficit in BOP or the ultimate recipient of any surplus.
True or False. The above statement is true because accommodating receipts are used to finance BOP deficit which occurs when autonomous receipts are less than autonomous payments.

A balance of payment account is a complete statement of a country's receipts and payments in foreign exchange resulting from international economic transactions. The structure is generally composed of three sections, namely, (i) Current Account,
(ii) Capital Account, and (iii) Reserve account (Overall Balance of payment). Current account is concerned with exports and imports of goods, services (invisibles) and unilateral transfers. Capital account consists of commercial borrowings, investments, capital transfers, etc. Overall balance of payment is the net result of total of current account and capital account after deficit in one account is offset with surplus in other account. We see in daily life that when an individual spends more than his income, he finances the difference (i) by borrowing or (ii) by selling his assets. Similarly, when a country faces a deficit in current account (i.e., when it spends more abroad than receives from sales), it finances the deficit either (i) by borrowing or (ii) by selling its assets (like stocks, bonds, etc.). Thus any current accounT deficit is necessarily financed by a net capital inflow.
Although transactions in BOP accounts are recorded in double entry book keeping yet official maintenance of these accounts is usually in single column as shown in the following table. Thus it is easy to explain the structure of BOP Account with the help of data relating to India's balance of payments for the year 2007-08. The following table is an extract from Government of India, Economic Survey 2008-09, Table showing summary of balance of payments.

Sources: Economic survey 2008-09
The above table shows current account deficit of र –45,343 crores because trade balance deficit of 286,276 crores is partially offset by invisibles account surplus of 240,923 crores. The capital account also shows surplus of 252,831 crores during the year 2007-08. Thus deficit in current account and surplus in capital account have resulted in overall surplus which is transferred to foreign exchange reserve leading to accumulation in foreign exchange reserve of the country. Since RBI used this surplus to purchase foreign currency assets, therefore, there was outflow of foreign currency to the tune of surplus, i.e., र 207,488 crores. So this outflow is shown as a negative entry. Indian economy was not significantly affected by global financial crisis which had set in around August 2007 as India received huge Foreign Institutional Investment (FII) during September 2007 to January 2008.
Balance of payments always balances. This balance is in accounting sense only because BOP accounts are prepared on the basis of system of double entry under which receipts are always equal to payments. As a result, this accounts are always in balance. Remember when a country is said to have favourable or unfavourable (adverse) balance of payment, it is in fact in the context of current account of BOP. The balance of current account need not be equal but can show surplus or deficit. The point to be noted here is that a deficit or surplus in current account is balanced by an equal amount of surplus or deficit in capital account. This deficit or surplus is met by transfer in capital account: (a) by borrowing from abroad, (b) by using SDRs of IMF, and (c) by drawing upon country’s foreign exchange reserves. Thus in accounting sense overall BOP always balances. BOP is a wider term inclusive of both balance of current account and balance of capital account and is always zero.

Economic activities generally create two types of transactions which lead to international payments and receipts. First concerns with production and sale of current output whereas the second concerns with purchase and sale of existing assets (both real and financial assets).
We have already learnt that in an open economy, final expenditure of consumers (C), Investors (I), Government (G) and Foreigners’ expenditure on our Exports (X) indicates nation's production of goods and services generating national income (Y). This can be represented in the following equation.
Y = C + I + G + X
This generated income is disposed of in the purchase of consumer goods and services (C), in making savings (S), in the payment of taxes (T) and in purchase of goods and services from abroad: (i.e., imports (M). Thus disposal of income can be shown in the following expression.
Y = C + S + T + M
Since according to national income accounting, income generated must be equal to income disposed of, therefore:
C + I + G + X = C + S + T + M
I + G + X = S + T + M
Clearly here I, G, X which partly represent generated income, are injections into income stream whereas S, T, M which partly represent disposal of income are leakages from income stream. As a result in equilibrium, planned injections must be equal to total planned leakages.

We have seen that overall account of BOP is always in equilibrium. This balance or equilibrium is only in accounting sense because deficit or surplus is restored with the help of capital account. Disequilibrium in BOP means there is either deficit or surplus in BOP. In fact, when we talk of disequilibrium, it refers to current account of balance of payment. If outflow of foreign, exchange is more than inflow of foreign exchange, deficit in balance of payment occurs reflecting disequilibrium in BOP.
(a) Causes of disequilibrium in BOP:
There are several factors which cause disequilibrium in the BOP indicating either surplus or deficit. Such causes for disequilibrium in BOP are listed below.
1.    Economic Factors. (i) Imbalance between exports and imports. (It is main cause of disequilibrium in BOP). (ii) Large scale development expenditure which cause large imports. (iii) High domestic prices which lead to imports. (iv) Cyclical fluctuations (like recession or depression) in general business activity. (v) New sources of supply and new substitutes.
2.    Political Factors. Experience shows that political instability and disturbances cause large capital outflows and hinder inflows of foreign capital.
3.    Social Factors. (i) Changes in fashions, tastes and preferences of the people bring disequilibrium in BOP by influencing imports and exports, (ii) High population growth in poor countries adversely affect their BOP because it increases the needs of the countries for imports and decrease their capacity to export.
(b) Measures to correct disequilibrium in BOP:
Sustained or prolonged deficit has to be settled by short term loans or depletion of official reserves of foreign exchange and gold. Following measures are recommended to avoid disequilibrium in BOP.
(i) Export promotion. Exports should be encouraged by granting various bounties to manufacturers and exporters. At the same time, imports should be discouraged by undertaking import substitution and imposing reasonable tariffs.
(ii)    Devaluation of domestic currency. It means fall in the external (exchange) value of domestic currency in terms of a unit of foreign exchange which makes domestic goods cheaper for the foreigners. Devaluation is done by a government order when a country has adopted a fixed exchange rate system. Care should be taken that devaluation should not cause rise in internal price level.
(iii)    Exchange control. Government should control foreign exchange by ordering all exporters to surrender their foreign exchange to the Central Bank and then ration out among licensed importers.
(iv)    Depreciation. Like devaluation, depreciation leads to fall in external purchasing power of home currency. Depreciation occurs in a free market system wherein demand for foreign exchange far exceeds the supply of foreign exchange in foreign exchange market of a country. (Mind, devaluation is done in fixed exchange rate system.)
(v)    Reducing inflation. Inflation (continuous rise in prices) discourages exports and encourages imports. Therefore, government should check inflation and lower the prices in the country,
(vi)    Import Restrictions and Import Substitution are other measures of correcting disequilibrium.

There are various concepts of exchange rate systems. Its two important types are Fixed Exchange Rate and Flexible Exchange Rate as explained below. (In between these two extreme rates, there are some hybrid systems like Crawling Peg, Managed Floating, etc. which combine merits of both fixed and flexible system of exchange rates. Broadly, when government decides the conversion rate, it is called fixed exchange rate and when market forces determine the rate, it is called flexible (floating) exchange rate.

(a)    Fixed Exchange Rate System. Fixed exchange rate is the rate which is officially fixed by the government/monetary authority on daily or monthly basis. Only a very small adjustment or deviation from this fixed values is possible. In this system foreign central banks stand ready to buy and sell their currencies at a fixed price. In case there is disequilibrium in balance of payment causing excess demand or excess supply of foreign exchange, Central bank of the country has to buy or sell required quantities of foreign exchange to eliminate the excess demand or supply. A typical kind of this system was used under Gold Standard System in which each country committed itself to convert freely its currency into gold at a fixed price. Thus value of each currency was defined in terms of gold, and therefore, exchange rate was fixed. The advantages of this system are as under:
Merits: (i) It ensures stability in exchange rate which encourages foreign trade, (ii) It contributes to the coordination of macro policies of countries in an interdependent world economy, (iii) Fixed exchange rate prevents capital outflow, (iv) It prevents speculation in foreign exchange market. (v) Fixed exchange rates are more conducive to expansion of world trade because it prevents risk and uncertainty in transactions.
Demerits: (i) Fear of devaluation. In a situation of excess demand, Central Bank uses its reserves to maintain fixed exchange rate. But when reserves are exhausted and excess demand still persists, government is compelled to devalue domestic currency. If speculators believe that exchange rate cannot be held for long, they buy foreign exchange in massive amount causing deficit in BOP. This may lead to larger devaluation. This is the main flaw of fixed exchange rate system, (ii) Benefits of free markets are deprived, (iii) There is always possibility of undervaluation or overvaluation.

Flexible (Floating) Exchange Rate. Flexible exchange rate is the rate which is determined by forces of supply and demand in the foreign exchange market. There is no official (govt.) intervention. Here the value of a currency is left completely free to be determined by market forces of demand and supply of the currencies concerned. Under this system, the central banks, without intervention, allow the exchange rate to adjust so as to equate the supply and demand for foreign currency. In India it is flexible exchange rate which is being determined. Merits and demerits of this system are listed below:
Merits. (i) Deficit or surplus in BOP is automatically corrected, (ii) There is no need for government to hold any foreign reserve, (iii) It helps in optimum resource allocation, (iv) It frees the government from problem of balance of payment, (v) Such rates are helpful in removing the barriers to trade and capital movements, (vi) Flexible exchange rate increases the efficiency in the economy by achieving best allocation of resources.
Demerits, (i) It encourages speculation leading to fluctuations in exchange rate, (ii) Wide fluctuations in exchange rate can hamper foreign trade and capital movement between countries, (iii) It generates inflationary pressure when prices of imports go up due to depreciation of currency caused by deficit in BOP. (iv) It discourages investment and international trade.

Meaning of foreign exchange rate. The price of one currency in terms of another is known as foreign exchange rate. It is the rate at which one unit of a foreign currency is exchanged for domestic currency. In other words it is the price in domestic currency to obtain one unit of foreign currency. For example, if one unit of US dollar can be got by paying र 50, then foreign exchange rate is 1 $ = र 50 (or र 1 = 1/50 dollar = 2 cents). Foreign exchange rate is sometime called as external value of currency.
(i) Nominal exchange rate. It is price of foreign currency in terms of domestic currency. When cost (price) of purchasing one unit of foreign currency (say, dollar) is quoted in terms of domestic currency (say, rupees), it is called nominal exchange rate because exchange rate is quoted in money terms, i.e., so many rupees per dollar. For instance, if 1 American dollar can be obtained (exchanged) for 50 Indian rupees, i.e., if it costs rupees 50 to buy 1 dollar, it will be called nominal exchange rate. Generally, exchange rate is expressed in the form of nominal exchange rate, i.e., so many units of home currency are to be paid to get one unit of foreign currency.
(ii) Real exchange rate. It is relative price of foreign goods in terms of domestic goods. When cost of purchasing one unit of domestic currency (say, rupees) is quoted in terms of foreign currency (say, dollar), it is called real exchange rate. For instance, in the above case it costs 2 cents (1 dollar = 100 cents) to buy 1 rupee. People who plan to visit America need to know how expensive American goods are relative to goods at home. Real exchange rate is equal to Nominal exchange rate multiplied by foreign price level and divided by domestic price level. Symbolically:

Meaning of foreign exchange market. The market in which national currencies of various countries are converted, exchanged or traded for one another is called foreign exchange market. Alternatively, it is the market where national currencies are traded for one another. It is not any physical place but is a network of communication system which connects the whole complex of institutions. It includes banks, specialised foreign exchange dealers, brokers and official government agencies through which the currency of one country can be exchanged (converted) for that of another. Again foreign exchange market is of two types — Spot market and forward market. 
Functions: Foreign exchange market performs three main functions, namely, (i) transfer function, (ii) credit function, and (iii) hedging function. Transfer function refers to transferring purchasing power between countries; credit function refers to providing credit channels for foreign trade and hedging function pertains to protecting against foreign exchange risks. Hedging is an activity which is designed to minimize risk of loss. When people want to operate in the foreign exchange market, it implies that they intend to buy or sell foreign exchange depending on their demand for or supply of foreign exchange. For instance, when we (Indian residents) buy foreign goods, say Japanese goods, it shows supply of rupees to foreign exchange market to be exchanged for Yen because seller of Japanese goods will expect payment in Yen only. Similarly, Indian exporters of their goods will expect to be paid in rupees for which foreigners will have to sell their currency in the exchange market to buy rupees in return. It shows demand for rupees in foreign exchange market. Transactions in foreign exchange market are reflected in the balance of payment account.

Demand for Foreign Exchange (US dollars). Remember, payments in foreign exchange cause demand for foreign exchange. The following factors cause (generate) demand for foreign exchange, i.e., foreign exchange is demanded by domestic residents for the following reasons:
 Sources of demand for foreign exchange:
(i)  To purchase goods and services by domestic residents from foreign countries.
(ii) To purchase financial assets (i.e., to invest in bonds and equity shares) by domestic residents in a foreign country.
(iii) To send gifts and grants abroad.
(iv) To invest directly in shops, factories, buildings in foreign countries.
(v)  To speculate on the value of foreign currencies.
(vi) To undertake foreign tours (or for travelling abroad) and
(vii) To make payments of international trade.
Continuing the above example, Indian people and firms demand US dollars to pay for goods and services they want to import from USA or to purchase assets or invest in US bonds or build factories in USA. Demand for dollars also arises from Indians who want to send gifts to some people in USA. Similarly, Indian students studying in USA or Indians travelling in USA require dollars to meet their education and travelling expenses.

Reasons for rise in demand for foreign currency when its price falls are: (i) Wien price of foreign currency falls, imports from that country become cheaper. For example, suppose price (exchange rate) of one US dollar falls say from र 50 to र 45, it means less rupees are required to buy one dollar worth of goods from US. So imports increase and hence demand for foreign currency rises, (ii) When foreign currency becomes cheaper in terms of domestic currency, it promotes tourism to foreign country. So this also raises demand for foreign currency.
In short, lower the price of US dollar, higher is the demand for US dollar and vice versa.

Supply of Foreign Exchange (US dollars). Supply of foreign exchange comes from foreigners who make us payment in foreign exchange (currency) for different purposes. The following factors cause supply of foreign exchange. As a result foreign currencies flow into domestic economy.
(i)    Sources of supply of foreign exchange.
(i)    When foreigners purchase home country's (say India's) goods and services through exports (by India).
(ii)    When foreigners invest in bonds and equity shares of the home country (say, India).
(iii)    When currency dealers and speculators cause flow of foreign currency in the domestic economy.
(iv)    When Indian workers working abroad send their savings to families in India. (Remittances).
(v)    When foreign tourists come to India.
Pursuing the above example, the Indian firms and the government which export Indian goods to USA will earn dollars from American residents. Similarly, Americans who travel in India and use services of Indian hotels and transport, will also supply dollars to be converted into rupees for meeting these expenses. Again, American companies and the individuals who buy assets in India will also supply dollars. Besides supply of dollars by the Indians working in USA popularly called 'remittances from USA' also add to the supply of dollars.

There is direct relation between price of foreign exchange and supply of foreign exchange. A fall in foreign exchange rate causes a fall in supply of foreign exchange (currency) whereas a rise in foreign exchange rate causes a rise in supply. That is why supply curve becomes upward sloping. 

Foreign exchange markets are sometimes classified in two categories spot market and forward market on the basis of the period of transaction carried out. There are explained below:
(a)    Spot Market. If the operation is of daily nature, it is called spot market or current market. It handles only spot transactions or current transactions. The exchange rate that prevails in the spot market for foreign exchange is called Spot Rate. Expressed alternatively, spot rate of exchange refers to the rate at which foreign currency is available on the spot. For instance, if one US dollar can be purchased for र 50 at the point of time in the foreign exchange market, it will be called spot rate of foreign exchange. No doubt, spot rate of foreign exchange is very useful for current transactions but it is also necessary to find what the spot rate is. In addition, it is also significant to find the strength of the domestic currency with respect to all of home country's trading partners. Note that the measure of average relative strength of a given currency is called Effective Exchange Rate (EER).
(b)    Forward Market. A market for foreign exchange for future delivery is known as Forward Market. It deals with transactions (sale and purchase of foreign exchange) which are contracted today but implemented sometimes in future. A market in which foreign exchange is bought and sold for delivery at a future date at an agreed rate today is called forward market. It covers transactions which occur at a future date. Exchange rate that prevails in a forward contract for purchase or sale of foreign exchange is called Forward Rate. Thus forward rate is the rate at which a future contract for foreign currency is made. This rate is settled now but actual transaction of foreign exchange takes place in future. Forward Market for foreign exchange covers transactions which occur at a future date. Forward exchange rate helps both the parties involved. A forward contract is entered into for two reasons (0 to minimise risk of loss due to adverse change in exchange rate (i.e., hedging), and (ii) to make a profit (i.e., speculation).
Two exchange rate quotes. In foreign exchange market, there are two exchange rate quotes, viz., Buying rate and Selling rate. If a person goes to the market to buy foreign exchange, say dollars, he has to pay higher rate than when he goes to sell dollars. For him buying rate is higher than selling rate.

Appreciation of a currency is the increase in its value in terms of another foreign currency. Thus currency appreciation takes place when there is a decrease in the domestic currency price of foreign currency. For instance, if the value of a rupee in terms of US dollar increases, say from र 50 to र 49 to a dollar, it will be called appreciation of Indian currency (i.e., rupee) because less rupees are required to buy one US dollar. This shows strengthening of the Indian rupee. So with same amount of money (Rupees), more goods can be purchased from US. It means imports from US have become cheaper. This may result in increase of imports by India from US. By contrast when Indian rupee in dollar terms appreciates, the dollar would depreciate. In short, lower exchange rate like $I = र 49 instead of र 50 means appreciation of Indian currency.
Appreciation vs. Revaluation. When a country raises the value of its currency in terms of foreign currency under a fixed rate regime, it is called revaluation. The effect of revaluation is the same as that of appreciation. Although both appreciation and revaluation convey the same thing, i.e., a rise in the value of domestic currency in terms of foreign currency but they take place in different regimes. Revaluation takes place by government order in Fixed Exchange Rate regime whereas appreciation occurs in Flexible Exchange Rate regime in a free exchange market depending upon forces of demand and supply of currency.

(ii)    Depreciation of a currency is fall in price of domestic currency (say, rupees) in terms of foreign currency (say, dollar). It means one dollar can be exchanged for more rupees. Its implication is that with the same amount of dollars more of goods can be purchased from India. This means Indian goods have become cheaper for Americans. This may result in increase of exports from India to America. Thus currency depreciation takes place when there is an increase in the domestic-currency-price of the foreign currency. For instance, if the value of rupee in terms of US dollar falls, say from र 50 to र 51 to a dollar, it will be a case of depreciation of Indian rupee because more rupees are required now to buy one US dollar. In short, higher exchange rate like $1 = र 51 instead of र 50 means depreciation of Indian currency.
Clearly appreciation or depreciation occurs under flexible exchange rate system. The exchange value of currency frequently appreciates or depreciates depending upon the change in the demand for and supply of currency.

Meaning of Crawling Peg, Managed Floating and Adjustable Peg

(i)    Crawling Peg. This is a compromise between fixed exchange rate and flexible exchange rate. According to Crawling Peg system, a country specifies a parity value for its currency and allows small adjustment i.e. permits a small variation around that parity (such as ± 1% from the parity). There is a ceiling and floor limit so that it can provide some discipline on the part of monetary authorities.

(ii)    Managed Floating (D 2010C). It is a system in which central bank allows the exchange rate to be determined by market forces but intervenes at times to influence the rate. This is a hybrid of fixed and flexible exchange rates. It is characterised by some intervention in the exchange rate movements. Under clean floating (i.e., flexible exchange rate), exchange rate is market-determined without any Central Bank intervention but in managed floating, Central Bank intervenes to restrict fluctuations in exchange rate with certain limits. Managed floating rate is like flexible rate but floating, i.e., fluctuation in exchange rate is allowed with certain limits by the government. There is no fixed parity value. The authorities intervene when a particular situation requires it.

(iii)    Adjustable Peg. Under this system, a country's exchange rate is allowed to fluctuate upward or downward from the par value of its currency within a margin of 1%.

 (i) Export promotion, (ii) Devaluation of domestic currency, (iii) Exchange control, and (iv) Depreciation.

(i)     Large imports due to large scale development expenditure.
(ii)    High domestic prices.
(iii)   New sources of supply and new substitutes.
(iv)   Political instability.
(v)    Changes in taste, fashion and preferences.

(i) Accommodating items refer to transactions that occur because of other activity in the BOP like government financing. Such transactions are accommodating transactions because they accommodate the requirements of BOP accounts.
(ii) Autonomous items in BOP accounts refer to international economic transactions that take place due to economic motives like profit maximisation. These are called autonomous items because they are independent of balance of payment considerations.

(i) Components of current account are (a) Export and import of goods, (b) Export and import of services, and (c) Unilateral transfers.
(ii) Various forms or components of capital account are (a) Private transactions, (b) Official transactions, (c) Direct investment, and (d) Portfolio investment.

Income generated by production and sale of current output is shown as:
Y = C + I + G + X
Income disposed of in the purchase of consumer goods, savings, taxes and imports is shown as:
Y = C + S + T+ M
Since income generated must be equal to income disposed of, therefore,
C + I + G + X = C + S + T + M I + G + X = S + T + M
Here I, G, X are injections and S, T, M are leakages from circular flow of income.
In equilibrium planned injections must be equal to total planned leakages.

(i) If the operation is of daily nature, it is called spot market or current market and the exchange rate that prevails in the spot market is called Spot Rate.
(ii) A market for foreign exchange for future delivery is known as forward market. Here foreign exchange is bought and sold for delivery at a future date.

(i) NEER is the measure of average relative strength of a given currency without eliminating the effect of price change.
(ii)    REER is an effective exchange rate based on real exchange rates instead of nominal rates.
(iii)    Real Exchange Rate (RER) is the exchange rate that is based on constant prices to eliminate the effect of price changes.

(i) A Crawling peg is a compromise between fixed and flexible exchange rates. According to it a country specifies a parity value for its currency and permits a small variation (such as +1%) from that parity.
(ii) Managed floating is a hybrid of fixed and flexible exchange rates. It is characterised by some intervention in exchange rate movement by monetary authorities but intervention is discretionary.

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In a system of flexible exchange rate, the exchange rate of a currency (like price of a commodity) is freely determined by forces of demand and supply of foreign exchange in the foreign exchange market. Expressed graphically, the intersection of demand and the supply curves determines the equilibrium exchange rate and equilibrium quantity of foreign currency. This is called equilibrium in foreign exchange market. Let us assume that there are two countries–India and USA – and the exchange rate of their currencies, viz., rupee and dollar is to be determined. Presently, there is floating or flexible exchange regime in both India and USA. Therefore, the value of currency of each country in terms of the other currency depends upon the demand for and supply of their currencies as explained below.
(a) Demand for foreign exchange. Demand for foreign exchange is caused (i) to purchase abroad goods and services by domestic residents, (ii) to purchase assets abroad, (iii) to send gifts abroad, (iv) to invest directly in shops, factories abroad, (v) to purchase foreign currency in anticipation of earnings profit (speculation), (vi) to undertake foreign tour, etc. The demand curve is downward sloping due to inverse relationship between foreign exchange rate and its demand vide Fig.(a).

(b)    Supply of foreign exchange. Supply of foreign exchange comes :
(i) when foreigners purchase home country's (say India's) goods and services through our exports, (ii) when foreigners make direct investment in bonds and equity shares of home country, (iii) when speculation cause inflow of foreign exchange, (iv) when foreign tourists come to home country, etc. The supply curve is upward sloping due to direct relationship between foreign exchange rate and its supply vide Fig.(a)

(c)    Determination of exchange rate. The equilibrium exchange rate is determined at a point where demand for and supply of foreign exchange are equal. Graphically intersection of demand and supply curves determine the equilibrium exchange rate of foreign currency. At any particular time, the price at which demand for foreign currency (say, dollar) equals its supply is called equilibrium rate of exchange. It is proved with the help of following diagram. The price on the vertical axis is stated in terms of domestic currency (i.e., how many rupees for one US dollar). The horizontal axis measures quantity demanded or supplied of foreign exchange (i.e., dollars). In this figure, demand curve is downward sloping which shows that less foreign exchange is demanded when exchange rate increases. The reason is that rise in the price of foreign exchange (dollar) increases the rupee cost of foreign goods which make them more expensive. The result is fall in imports and demand for foreign exchange.

The supply curve is upward sloping which implies that supply of foreign exchange increases as the exchange rate increases. Home country's goods (here Indian goods) become cheaper to foreigners because rupee is depreciating in value. As a result demand for Indian goods increases. Thus our exports should increase as the exchange rate increases. This will bring greater supply of foreign exchange. Hence the supply of foreign exchange increases as the exchange rate increases which proves the slope of supply curve.

In Fig.(a) demand curve and supply curve of dollar intersect each other at point E which implies that at exchange rate of OR (QE), quantity demanded and supplied are equal (both being equal to OQ). Hence equilibrium exchange rate is OR and equilibrium quantity is OQ.

(d)    Change in Exchange Rate. An increase in India's demand for US dollars, supply remaining the same will cause the demand curve DD to shift to D'D'. The resulting intersection will be at a higher exchange rate, i.e., exchange rate (price of dollar in terms of rupees) will rise from OR to OR₁ (Say from $1 = र 50 to $1 = र 52). It shows depreciation of Indian currency (rupees) because more rupees (र 52 instead of र 50) are required to buy one US dollar. Thus depreciation of a currency means ‘a fall in the price of home currency’. Likewise an increase in supply of US dollar will cause supply curve SS to shift to S'S' and as a result exchange rate will fall from OR to OR₂ (Say from $1 = र 50 to $1 = र 48). It indicates appreciation of Indian currency (rupees) because cost of US dollar in terms of rupee has now fallen, i.e., less rupees (र 48 instead of र 50) are required to buy one US dollar or a dollar fetches more rupees. Thus appreciation of currency means a rise in the price of home currency’.

Note: II may be noted that American dollars. British pounds, French francs and Japanese yen are considered Strong or Hard currencies as worldwide people have faith in their general acceptance as money. Indian Rupees and currencies of developing countries are considered Soft currencies since their exchange value is weak.

Fig. (a)

The Balance of Payments (Bop) records the transactions in goods, services and assets between residents of a country with the rest of the world for a specified time period typically a year.
Capital account of BoP records public and private investment, and lending activities. It is the net change in foreign ownership of domestic assets.
The following are the three broad categories of transactions recorded under capital account
of BOP.
1. Foreign Investment – Foreign investment is bifurcated into Foreign Direct Investment
(FDI) and portfolio investment. FDI is the act of purchasing an asset and at the same time acquiring control on it. The FDI can be in the form of inflow of investment (credit) and outflow in the form of disinvestments (debit) or abroad in the reverse manner.
Portfolio investment is the acquisition of an asset, without control over it. Portfolio investment comes in the form of Foreign Institutional Investors (FIIs), offshore funds and Global Depository Receipts (GDRs) and American Depository Receipts (ADRs).

2. Loans and Borrowings - Loans are further classified into external assistance, medium and long-term commercial borrowings and short-term borrowings. Loans and borrowings by a country from the foreign countries or from the international money market are recorded in the Capital Account of the BOP. These borrowings can be in the form of commercial borrowings or in the form of assistance. When a country borrows with the consideration of assistance, the transaction would involve a lower rate of interest as compared to the prevailing market rate of interest. As against this, commercial borrowings involve open market rate of interest. Loans and borrowings result in inflow of foreign exchange into the country. Hence, they are recorded as positive items in the Capital Account of BOP. Unlike FDI and Portfolio Investments, loans and borrowings are debt creating capital transactions.
3. Banking Capital Transactions- Banking capital comprises external assets and liabilities of commercial and government banks authorized to deal in foreign exchange, and movement in balance of foreign central banks and international institutions like, World Bank, IDA, ADB and IFC maintained with RBI. Non-resident (NRI) deposits are an important component of banking capital.
Or

Current account refers to an account which records all the transactions relating to export and import of goods and services and unilateral transfers during a given period of time. Current account contains the receipts and payments relating to all the transactions of visible items, invisible items and unilateral transfers.
Components of Current Account: The main components of Current Account are:
1. Export and Import of Goods (Merchandise Transactions or Visible Trade):
A major part of transactions in foreign trade is in the form of export and import of goods (visible items). 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). Balance of these visible exports and imports is known as balance of trade (or trade balance). 
2. Export and Import of Services (Invisible Trade):
It includes a large variety of non- factor services (known as invisible items) sold and purchased by the residents of a country, to and from the rest of the world. Payments are either received or made to the other countries for use of these services.
Services are generally of three kinds:
(a) Shipping,
(b) Banking, and
(c) Insurance.

Payments for these services are recorded on the negative side and receipts on the positive
side.
3. 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. Receipt of unilateral transfers from rest of the world is shown on the credit side and unilateral transfers to rest of the world on the debit side.
4. Income receipts and payments to and from abroad:
It includes investment income in the form of interest, rent and profits.

Sale of machinery to abroad (exports) will be recorded as positive item in the current account of BOP.
Current account refers to an account which records all the transactions relating to export and import of goods and services and unilateral transfers during a given period of time. Current account contains the receipts and payments relating to all the transactions of visible items, invisible items and unilateral transfers. Those transactions that result in a inflow of foreign exchange in the country are recorded as positive items in the current account of BOP. On the other hand, those items that lead to an outflow of foreign exchange from the country are recorded as negative items in the current account of BOP. Therefore, as sale of machinery abroad leads to an inflow of foreign exchange in the country it will be recorded as a positive item in the current account of BOP.

Inflationary gap is also referred to as excess demand. When aggregate demand is greater than aggregate supply, at full employment level in the economy, it is referred to as inflationary gap or excess demand. This situation actually results in an increase of prices, that is inflation.
Graphically, it is represented by the vertical distance between the actual level of aggregate demand (ADE) and the full employment level of output (ADF).

In the figure, EY denotes the aggregate demand at the full employment level of output and FY denotes the actual aggregate demand. The vertical distance between these two represents inflationary gap. That is,
FY – EY = FE (Inflationary Gap)
In the figure, AD₁ and AS represent the aggregate demand curve and aggregate supply
curve respectively. The economy is at full employment equilibrium at point “E”, where AD₁ intersects AS curve. At this equilibrium point, OY represents full employment level and EY is aggregate demand at the full employment level of output.
Suppose that the actual aggregate demand for output is FY, which is higher than EY. This implies that actual aggregate output demanded by the economy FY is more than the potential (full employment) aggregate output EY. Thus, the economy is facing surplus demand. This situation is termed as excess demand. As a result of the excess demand, inflationary gap arises. The inflationary gap is measured by the vertical distance between the actual aggregate demand for output and the potential (or full employment level) aggregate demand. In other words, the distance between FY and EY, i.e. FE represents the inflationary gap.
Repo rate refers to the rate at which the central bank lends to the commercial bank. In case of inflationary gap, the central bank would increase repo rate. An increase in the repo rate increases the cost of borrowings for the commercial banks. This discourages the demand for loans and borrowings. Thereby, the consumption expenditure falls, and hence aggregate demand falls.
Or

Deflationary gap is otherwise called as deficit demand. It is a situation where aggregate demand is less than aggregate supply at the level of full employment. Graphically, it is represented by the vertical distance between the aggregate demand at the full employment level of output (ADF) and the actual level of aggregate demand (ADE). In the figure below, EY denotes the aggregate demand at full employment level of output and CY denotes the actual aggregate demand. The vertical distance between these two represents deflationary gap.

EY – CY = EC (Deflationary Gap)
In the figure, AD₁ and AS represent the aggregate demand curve and aggregate supply curve. The economy is at full employment equilibrium at point “E”, where AD₁ intersects at AS curve. At this equilibrium point, OY represents the full employment level of output and EY is the aggregate demand at the full employment level of output.
Let us suppose that the actual aggregate demand for output is only CY, which is lower than EY. This implies that actual aggregate output demanded by the economy CY falls short of the potential (full-employment) aggregate output EY. Thus, the economy is facing a deficiency in demand. This situation is termed as deficit demand. As a result of the deficit demand, deflationary gap arises. The deflationary gap is measured by the vertical distance between the potential (or full employment level) aggregate demand and the actual aggregate demand for output. In other words, the distance between EY and CY,
i.e. EC represents the deflationary gap.
To correct deflationary gap, the central bank purchases the securities in the market through Open market operations (OMO). It refers to the buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system. Through OMO, the flow of money is increased and subsequently enhancing the purchasing power of the people. The higher purchasing power increases the aggregate demand.

Balance of Trade is simply the difference between the value of exports and value of imports. It denotes the differences of imports and exports of a merchandise of a country during the course of year. Balance of Trade (BOT) for a country refers to the record of visible trade transactions of the country with the rest of the world. 

The deficit in the BOP is governed by the balance of autonomous transactions in the BOP. The BOP would show a deficit if the autonomous receipts are lesser than the autonomous payments. As autonomous receipts implies a receipt of foreign exchange and autonomous payments implies a payment of foreign exchange, so, it can be said that BOP would show a deficit if the foreign exchange receipts are less than foreign exchange payments. In other words, the BOP deficit would be reflected in a depletion of foreign exchange reserves of the country.

With a rise in the import duty of gold, the cost of gold increases and thereby the import of gold will fall. This reduces the demand for foreign currency. With the supply of foreign currency remaining same, the foreign exchange rate would fall. This implies appreciation of rupees. This can be explained with the help of the following diagram.

In the diagram, DD and SS are the initial demand curve and supply curve for foreign currency respectively. E is the initial equilibrium point, with OR as the equilibrium exchange rate. A fall in the demand for foreign currencies (due to a fall in imports) shifts the demand curve from DD to D' D'. With the shift in demand curve, new equilibrium is established at point E, where the exchange rate falls from OR to OR₁. A fall in the exchange rate implies currency appreciation.

An increase in foreign direct investment leads to increase in the supply of foreign currency, thereby, the price of foreign exchange falls.

When the domestic currency appreciates, demand for imports by the native residents also increases. This is because appreciation of domestic currency implies depreciation of foreign currency. When domestic currency appreciates, imports become cheaper and there by the demand for import increases.
For example, a currency appreciation (fall in the exchange rate) from say, $1= Rs 40 to $1= Rs 38 implies that the goods from abroad become cheaper (that is, it now cost Rs 38 to purchase a commodity worth $1 instead of Rs 40 earlier). This would result in a rise in the demand for the imports.

Managed floating exchange rate system is the combination of two systems of exchange rate, namely, fixed exchange rate and floating exchange rate. On one hand, the foreign exchange market is allowed to operate freely and on the other hand, there is an official declaration of rules or guidelines for the intervention by the monetary authority. That is, under this system the exchange rate is determined through the market forces with intervention of the monetary authority as and when required. 

Autonomous Items in BOP- Autonomous items refer to international economic transactions that take place due to some economic motives like earning income and profit maximisation. Such transactions are independent of the state of country’s balance of payment. These items are generally called ‘above the line items’ in BOP again, it is autonomous transactions which make deficit or surplus in BOP. BOP is in deficit if the autonomous receipts are less than autonomous payments. BOP is in surplus if the autonomous receipts are greater than autonomous payments.
Accommodating Items in BOP- Accommodating items refers to those international economic transactions that are not undertaken with the motive of earning profit such as government financing, injection or withdrawal from the official reserves. Such transactions are undertaken as a consequence of the autonomous transactions. In other words, they are compensating short-term capital transactions that are undertaken to correct the disequilibrium in the autonomous items.
The deficit in the BOP is governed by the balance of autonomous transactions in the BOP. The BOP would show a deficit if the autonomous receipts are lesser than the autonomous payments. As autonomous receipts implies a receipt of foreign exchange and autonomous payments implies a payment of foreign exchange, so, it can be said that BOP would show a deficit if the foreign exchange receipts are less than foreign exchange payments. In other words, the BOP deficit would be reflected in a depletion of foreign exchange reserves of the country.

Foreign exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country's currency in terms of another currency.

(1) Borrowings and Lendings to and from abroad:
All transactions relating to borrowings from abroad by private sector, government, etc. Receipts of such loans and repayment of loans by foreigners are recorded on the positive (credit) side. All transactions of lending to abroad by private sector and government. Lending abroad and repayment of loans to abroad is recorded as negative or debit item.
(2) Investments to and from abroad:
Investments by rest of the world in shares of Indian companies, real estate in India, etc. Such investments from abroad are recorded on the positive (credit) side as they bring in foreign exchange. Investments by Indian residents in shares of foreign companies, real estate abroad, etc. Such investments to abroad be recorded on the negative (debit) side as they lead to outflow of foreign exchange.
(3) Changes in foreign exchange reserves:
The foreign exchange reserves are the financial assets of the government held in the central bank. A change in reserves serves as the financing item in India’s BOP. So, any withdrawal from the reserves is recorded on the positive (credit) side and any addition to these reserves is recorded on the negative (debit) side.

When the price of foreign currency rises then it implies that foreign goods have become expensive for the domestic residents of the country. This results in a fall in the demand for foreign goods by the domestic residents. Consequently, the demand for foreign currency falls.
For example, suppose the rupee-dollar exchange rate (price of dollars in terms of rupees) rises from say, from $1= Rs 50 to $1= Rs52. This implies that in order to purchase one dollar worth of foreign goods, the domestic residents now have to pay Rs 52 instead of Rs 50. Thereby, the demand for foreign goods decreases. Consequently, the demand for dollars decreases.

When the price of foreign currency rises, this implies that the domestic goods have become cheaper for the foreign residents. This is because they can now buy more goods and services with same worth of foreign currency. As a result, the foreign demand for domestic products rises. This leads to an increase in the exports of domestic country. As a result, the domestic country receives more foreign currency and its supply rises.
For example, suppose the rupee-dollar exchange rate (price of dollars in terms of rupees) rises from say, from $1= Rs 50 to $1= Rs 52. This implies that the foreign residents can now buy Rs 52 worth of goods with the same one dollar. Thus, the demand for domestic goods increases. As a result, the supply of dollars increases.

The correct option is (c). An autonomous item in balance of payment refers to foreign exchange transactions which are made independently of the state of the balance of payment, such as profit motive.

In the diagram, the supply curve is given as the SS curve and –C represents negative savings. At the breakeven Point B, we find that Y = C and S = O.
Derivation of the consumption curve from the saving curve: Given the SS curve, let us consider OS = OC. At Point B, draw a perpendicular 45° line towards Point A. Points C and A are joined to produce a straight line upward sloping consumption curve CC.

Indian investors lending abroad leads to an outward flow of foreign exchange and is hence treated as a negative item in the capital account of balance of payments.
b. This will reduce the supply of foreign currency from SS to S′S. Hence, the new equilibrium is reached at Point E′ with a new exchange rate OR₁.

Balance of payments (BOP) defines a systematic record of all economic transactions between the domestic country and the rest of the world during a particular period of time.In other words it records the inflow of foreign exchange into the country and foreign exchange from the country.

The demand for foreign currency fall and supply rises when its price rises because domestic goods become cheaper. It induces the foreign currency to increase their imports from the domestic country. When the price of the foreign currency increases, this implies that the domestic currency has increased in terms of the foreign currency.in other words, it means that the domestic currency has depreciated.
For example, if price of 1US dollar rises from Rs 53 to Rs 59, it implies that exports to US will increase as Indian goods will become relatively cheaper. It will raise the supply of US dollars.