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BEST HIGH/HIGHER SECONDARY SCHOOL Chapter 6 Balance of payments

Balance of Payment

Balance of payment : Meaning and componenets

Meaning :- The balance of payment of a country is a systematic record of all economic transactions between the residents of the reporting country and the residents of foreign countries during a given period of time

Balance of trade and balance of payment :Balance of trade takes into account only those transactions arising out of the exports and imports of goods(the visible items).It does not consider the exchange of services rendered such as shipping. Balance of payments takes into account the exchange of both visible and invisible items. Hence, the balance of payments represents a better picture of a countrys economic transactions with the rest of the world than the Balance of Trade. Structure of Balance of Payments Accounts :A Balance of payments statements is a summary of a nations total economic transactions undertaken on international account. It is usually composed of two sections :1) Current Account 2) Capital Account

1) Current Account :- It records the following 3 items :-

i) Visible items of trade :- The balance of export and import of goods is called the balance of visible trade eg. Tea, Coffee etc. ii) Invisible trade :- The balance of exports and imports of services is called the balance invisible trade eg. Shipping, insurance etc. iii) Unilateral transfers :- Unilateral transfer are receipts which residents of a country make without getting anything in return eg. Gifts etc. The net balance of visible trade, invisible trade and of unilateral transfers is the balance on current account. 2) Capital Account :- It records are international transactions that involve a resident of the domestic country changing his assets with a foreign resident or his liabilities to a foreign resident.

Various forms of capital account transactions :1) Private Transactions :- There are transactions that effect the liabilities and assets of individuals. 2) Official Transactions :- Transactions affecting assets and liabilities by the govt. and its agencies. 3) Portfolio Investment :- It is the acquisition of an asset that does not give the purchaser control over the asset. 4) Direct Investment :- It is the act of purchasing an asset and at the same time acquiring control of it. The net value of the balance of direct and portfolio investment is called the balanced on Capital Account.

Other items in the balance of payments:These are included since the full balance of payments account must balance. These are as follows i) Errors and omissions :- These may arise due to the presence of sampling error or dishonesty. ii) Official reserve transactions :- All transactions excepts those in the category of autonomous transactions. Autonomous Items :Autonomous items in BOP refer to international economic transactions that take place due to some economic motive. Such as profit maximization. These items are often called above the line items in BOP.

The BOP is in deficit if autonomous receipts are less than autonomous payments. The monetary authorities may finance a deficit by depleting their reserves of foreign currencies or by borrowing from the IMF. Accommodating Items :- Accommodating items in the BOP refer to transactions that occur because of other activities in the BOP, such as government financing. Accommodating items are also referred to as below the line items. Disequilibrium in BOP :There are number of factors that cause disequilibrium in the BOP. Showing either a surplus or deficit. These are categorized in three factors:i) ii) iii) Economic factors Political factors Social factors

Very Short Answer type Question ( 1 Mark each ) Q1. What is meant by balance payment? Ans. The balance of payment of a country is a systematic record of all economic transactions between the residents of the reporting country and the residents of foreign countries during a given period of time Q2:- What is meant by balance of trade? Ans. Balance of trade takes into account only those transactions arising out of the experts and imports of goods(the visible items).It does not consider the exchange of services. Q3. Give two examples of invisible items of balance of payments. Ans. The two examples of invisible items of balance of payments are:1) Services like shipping, insurance banking 2) Expenditure by tourists. Q4. Name the two accounts of balance of payment. Ans. 1) Current account 2) Capital account Q5. What type of activities are recorded in the current account of balance of payment? Ans. The current account records imports and exports of goods and services and unilateral transfers. Q6. What type of transactions are recorded in the capital account of balance of payments?

Ans. The capital account records all international transactions that involve a resident of the domestic country changing his assets with a foreign resident or his liabilities to a foreign resident. Q7. What are unilateral transfers or unrequited transfers? Ans. Unilateral transfer are receipts which residents of a country make without getting anything in return eg. Gifts etc. The net balance of visible trade, invisible trade and of unilateral transfers is the balance on current account. Q8. Are exports and imports recorded as positive or negative items in foreign exchange? Ans. Exports cause an inflow of foreign exchange into the country so they are entered as positive items. Imports cause an outflow, so they are entered as a negative item. Q9. Give an example of private unrequited transfers. Ans. Gifts that domestic residents receive from or make to foreign residents eg. An Indian resident working in Dubai sending back money to their relative in India. Q10. Give an example of official unrequited transfers. Ans. Receipt of or giving of foreign aid from development countries to developing countries. Q11. What is meant by Portfolio Investment in the capital account transactions? Ans. Portfolio Investment is the acquisition of an asset that does not give the purchaser control over the asset. For eg. Investment in the purchase of shares in a foreign company or of bonds issued by a foreign govt. Q12. What is meant by Direct Investment in the capital account transactions? Ans. Direct investment is the act of purchasing an asset and at the same time acquiring control of it. For example, acquisition of a firm in one country by a firm in another country. Short Answer Questions :Q1. Differentiate between balance of payment and balance of trade. Ans.

Balance of Trade 1. Balance of trade is a record of only visible items i.e. exports and imports of goods. 2. Balance of trade is a narrower concept as it is only a part of the balance of payments account. 3. Balance of trade can be in a deficit, surplus or balanced

Balance of Payments 1. Balance of payments is a record of both visible items (goods) and invisible items (services) 2. Balance of payments is a wider and more useful concept as it is a record of all transactions in foreign exchange. 3. Balance of payments must always balance
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Q2. Explain the components of capital account Ans. It records are international transactions that involve a resident of the domestic country changing his assets with a foreign resident or his liabilities to a foreign resident. Various forms of capital account transactions :1) Private Transactions :- There are transactions that effect the liabilities and assets of individuals. 2) Official Transactions :- Transactions affecting assets and liabilities by the govt. and its agencies. 3) Portfolio Investment :- It is the acquisition of an asset that does not give the purchaser control over the asset. 4) Direct Investment :- It is the act of purchasing an asset and at the same time acquiring control of it. The net value of the balance of direct and portfolio investment is called the balanced on Capital Account. Q3. Describe the cause for disequilibrium in the BOP. Ans. The cause of disequilibrium in the BOP are :1) Economic Factors :- Large scale development expenditure that may cause large imports Cyclical fluctuations in general business activity such as recession or depression. High domestic prices may result in increase in imports.

New sources of supply, new and better substitutes to existing products and changes in costs will bring about a change in trade flows and hence BOP over a period of time. 2) Political Factors :- Political instability can cause large capital outflows and reduce the inflow of foreign capital. 3) Social Factor :- Changes in tastes, preferences and fashion may affect imports and exports and hence the balance of trade Q4 Differences between internal trade and international trade?
Ans Mobility in Factor Of Production Domestic Trade: Free to move around factors of production like land, labor, capital and labor capital and entrepreneurship from one state to another within the same country International Trade: Quite restricted 2. Movement Of Goods Domestic trade: Easier to move goods without much restrictions. Maybe need to paysales tax,etc

International Trade: Restricted due to complicated custom procedures and trade barriers like tariff, quotas or embargo 3. Usage of different currencies Domestic trade: Same type of currency used International trade: Different countries used different currencies 4. Broader markets Domestic trade: Limited market due to limits in population, etc International trade: Broader markets 5. Language And Cultural Barriers Domestic trade: Speak same language and practice same culture International trade: Communication challenges due to language and cultural barriers

Long Answers 5 marks 1. Differentiate between balance of payment and balance of trade
Following is the list which is showing difference between balance of trade and balance of payment. It has been made on some basis.

Basis of Difference

Balance of Trade (BOT)

Balance of Payment (BOP) Balance of payment is flow of cash between domestic country and all other foreign countries. It includes not only import and export of goods and services but also includes financial capital transfer. BOP = BOT + (Net Earning on foreign investment - payment made to foreign investors) + Cash Transfer + Capital Account +or Balancing Item or BOP = Current Account + Capital Account + or - Balancing item ( Errors and omissions)
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1. Definition

Balance of trade may be defined as difference between export and import of goods and services.

2. Formula

BOT = Net Earning on Export - Net payment for imports

3. Favourable or Unfavourable

If export is more than import, at that time, BOT will be favourable. If import is more than export, at that time, BOT will be unfavourable.

Balance of Payment will be favourable, if you have surplus in current account for paying your all past loans in your capital account. Balance of payment will be unfavourable, if you have current account deficit and you took more loan from foreigners. After this, you have to pay high interest on extra loan and this will make your BOP unfavourable. To stop taking of loan from foreign countries.

4. Solution of Unfavourable Problem

To Buy goods and services from domestic country.

5. Factors

Following are main factors which affect BOT a) cost of production b) availability of raw materials c) Exchange rate d) Prices of goods manufactured at home If you see RBI' Overall balance of payment report, it shows debit and credit of current account. Credit means total export of different goods and services and debit means total import of goods and services in current account.

Following are main factors which affect BOP a) Conditions of foreign lenders. b) Economic policy of Govt. c) all the factors of BOT

6. Meaning of Debit and Credit

Credit means to receipt and earning both current and capital account and debit means total outflow of cash both current and capital account and difference between debit and credit will be net balance of payment.

FOREIGN EXCHANGE RATE


Foreign Exchange refers to all currencies other than the domestic currency of a given country. Foreign exchange rate is the rate at which currency of one country can be exchanged for currency of another country. FIXED EXCHANGE RATE SYSTEM: Fixed exchange rate is the rate which is officially fixed by the government, monetary authority and not determined by market forces.
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FLEXIBLE EXCHANGE RATE: Flexible exchange rate is the rate which is determined by forces of supply and demand in the foreign exchange market. DEMAND AND SUPPLY FOR FOREIGN EXCHANGE Demand for foreign exchange: 1. 2. 3. 4. 5. 6. 7. To purchase goods and services from other countries To send gifts abroad To purchase financial assets (shares and bonds) To speculate on the value of foreign currencies To undertake foreign tours To invest directly in shops, factories, buildings To make payments of international trade.

Supply of foreign exchange: Foreign currencies flow into the domestic economy due to the following reason. 1. When foreigners purchase home countries goods and services through exports 2. When foreigners invest in bonds and equity shares of the home country. 3. Foreign currencies flow into the economy due to currency dealers and speculators. 4. When foreign tourists come to India 5. When Indian workers working abroad send their saving to families in India. EQUILIBRIUM IN THE FOREIGN EXCHANGE MARKET The equilibrium exchange rate is determined at a point where demand for and supply of foreign exchange are equal. Graphically interaction of demand and supply curve determines the equilibrium exchange rate of foreign currency. y D
Rate of Exchange

S$

PE

D$ Q Demand and supply of US$ VERY SHORT ANSWER QUESTIONS. 1. Define foreign exchange rate.
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Ans: Foreign exchange rate is the rate at which currency of one country can be exchanged for currency of another country. 2. What do you mean by Foreign Exchange Market? Ans: The foreign exchange market is the market where international currencies are traded for one another. 3. What is meant by Fixed Exchange Rate? Ans: Fixed Rate of exchange is a rate that is fixed and determined by the government of a country and only the government can change it. 4. What is equilibrium rate of exchange? Ans: Equilibrium exchange rate occurs when supply of and demand for foreign exchange are equal to each other. 5. Define flexible exchange rate. Ans: Flexible rate of exchange is that rate which is determined by the demand and supply of different currencies in the foreign exchange market. 6. What is meant by appreciation of currencies? Ans: Appreciation of a currency occurs when its exchange value in relation to currencies of other country increases. 7. Define Spot exchange rate. Ans: The spot exchange rate refers to the rate at which foreign currencies are available on the sport. 8. Define forward market. Ans: Market for foreign exchange for future delivery is known as the forward market. 9. What is meant by balance of payments? Ans: Balance of payments refers to the statement of accounts recording all economic transactions of a given country with the rest of the world. 10. What do you mean by balance of trade? Ans: Balance of trade is the difference between the value of imports and exports of only physical goods. 11. The balance of trade shows a deficit of Rs. 600 crores, the value of exports is Rs.1000 crores. What is value of Imports? Ans: Balance of Trade = Exports of goods import of goods Import of good = Export of goods (B.O.T) = 1000- (-600) = Rs. 1600.
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12. What is the balance of visible items in the balance of payments account called? Ans:- Balance of trade 13. What do you mean by disequilibrium in BOP? Ans:- Disequilibrium in BOP is means either there is a surplus or deficit in balance of payment account. 14. List two items of the capital account of BOP account. Ans:- i) external assistance ii) commercial borrowing iii) foreign investment

15. Which transactions bring balance in the BOP account? Ans:- Accommodating transactions bring balance in the BOP account. 16. Define autonomous items in BOP. Ans:- Autonomous items in BOP refers to international economic transaction that take place due to some economic motive such as profit maximization. These items are independent of the state of the country balance of payments. 17. What is the other name of autonomous items in the BOP? Ans:- The other name of autonomous items in BOP is above the line item. 18. When does a situation of deficit in BOP arises? Ans:- A situation of deficit in BOP arise when autonomous receipts are less than autonomous payments. 19. What is meant by managed floating? Ans:- It is a system that allows adjustments in exchange rate according to a set of rules and regulations which are officially declared in the foreign exchange market. 20. What is meant by dirty floating? Ans:- Manipulate the exchange rate without following the guidelines issued by IMF is called dirty floating. ANSWER QUESTIONS (3 / 4 MARKS) 1. Why is foreign exchange demanded? Ans:- Foreign exchange is demanded for the following purposes. a) b) c) d) Payment of International loans Gifts and grants to rest of the world Investment in rest of the world. Direct purchases abroad for goods and services as well as imports from rest of the world.
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2. What determines the flow of foreign exchange in to the country? Ans: - Following factors contribute to the flow of foreign exchange in to the country. a) Purchases of domestic goods by the foreigners b) Direct foreign investment and portfolio investment in the home country. c) Speculative purchase of foreign exchange. d) When foreign tourists come to India. 3. Why does the demand for foreign exchange rise, when it price falls? Ans:- With a fall in price of foreign exchange , the exchange value of domestic currency increases and that of foreign currency falls. This implies that foreign goods become cheaper and their domestic demand increases. The rising domestic demand for foreign goods implies higher demand for foreign exchange. So there is inverse relationship between price and demand for foreign exchange. 4. When price of a foreign currency falls, the supply of that foreign currency also fall why? Ans: When price of a foreign currency falls it makes exports, investment by foreign residents costlier as a result supply of foreign currency falls. 5. Distinguish between autonomous and accommodating transaction of balance of payment account. Ans: Autonomous transactions are done for some economic consideration such as profit, such transactions are independent of the state of B.O.P. Accommodating transactions are under taken to cover the deficit/surplus in balance of payments. 6. Give two examples explain why there is a rise in demand for a foreign currency when its price falls. Ans: When price of foreign currency falls, imports are cheaper. So, more demand for foreign exchange by importers. Tourism abroad is promoted as it becomes cheaper. So demand for foreign currency rises. 7. Distinguish between fixed and flexible foreign exchange rate. Ans: When foreign exchange rate is fixed by Central Bank/government, it is called fixed exchange rate. When foreign exchange rate is determined by market forces/mechanism, it is flexible exchange rate.
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