1.
Unit 5

2.
BALANCE
OF
PAYMANT ACCOUNT

3.
BALANCE OF PAYMANT ACCOUNT
• MEANING
• The balance of payments of a country is a systematic record of all its economic
transactions with the outside world in a given year. It is a statistical record of the
character and dimensions of the country’s economic relationships with the rest of
the world.
• When a payment is received from a foreign country, it is a credit transaction while
payment to a foreign country is a debit transaction.
The principal items shown on the credit side (+) are
 exports of goods and services
 unrequited (or transfer) receipts in the form of gifts, grants, etc. from foreigners
 borrowings from abroad etc.
The principal items on the Debit side (-) include
 imports of goods and services
 transfer (or unrequited) payments to foreigners as gifts, grants, etc.
 lending to foreign countries
 investments by residents to foreign countries, and official purchase of reserve
assets or gold from foreign countries and international agencies.

4.
Components of Balance of Payments:
• (1) Current Account
• (2) Capital Account
(1) Current Account:
• 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.

5.
Current Account
The main components of Current Account are:
• Visible Trade
• Invisible Trade
VISIBLE TRADE
• Export and Import of Goods (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).

6.
INVISIBLE TRADE
1 Export and Import of Services
• 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.
2. 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.
3. Income receipts and payments to and from abroad:
• It includes investment income in the form of interest, rent and profits.

7.
CAPITAL ACCOUNT
• Capital account of BOP records all those transactions,
between the residents of a country and the rest of the world,
which cause a change in the assets or liabilities of the
residents of the country or its government. It is related to
claims and liabilities of financial nature.
• The main components of capital account are:
• 1. Borrowings and landings to and from abroad
• 2. Investments to and from abroad
• 3. Change in Foreign Exchange Reserves

8.
Borrowings and landings to and from abroad: It includes:
 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.
Investments to and from abroad: It includes:
 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.
Change 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. It must be
noted that ‘change in reserves’ is recorded in the BOP account and not ‘reserves’.

9.
Fixed Exchange Rate
system

10.
• In a fixed exchange rate system, the monetary authority picks
rates of exchange with each other currency and commits to
adjusting the money supply, restricting exchange transactions
and adjusting other variables to ensure that the exchange
rates do not move. All variations on fixed rates reduce the
time inconsistency problem and reduce exchange rate
volatility, albeit to different degrees.
• Under a fixed exchange rate system, DEVALUATION AND
REVALUATION are official changes in the value of a country's
currency relative to other currencies.

11.
Advantages Of Fixed Exchange Rates
• Certainty - with a fixed exchange rate, firms will always know
the exchange rate and this makes trade and investment less
risky.
• Absence of speculation - with a fixed exchange rate, there
will be no speculation if people believe that the rate will stay
fixed with no revaluation or devaluation.
• Constraint on government policy - if the exchange rate is
fixed, then the government may be unable to pursue extreme
or irresponsible macro-economic policies as these would
cause a run on the foreign exchange reserves and this would
be unsustainable in the medium-term.

12.
Disadvantages Of Fixed Exchange
Rates
 The economy may be unable to respond to shocks - a fixed exchange rate means
that there may be no mechanism for the government to respond rapidly to
balance of payments crises.
 Problems with reserves - fixed exchange rate systems require large foreign
exchange reserves and there can be international liquidity problems as a result.
 Speculation - if foreign exchange markets believe that there may be a revaluation
or devaluation, then there may be a run of speculation. Fighting this may cost the
government significantly in terms of their foreign exchange reserves.
 Deflation - if countries with balance of payments deficits deflate their economies
to try to correct the deficits, this will reduce the surpluses of other countries as
well as deflating their own economies to restore their surpluses. This may give the
system a deflationary bias.
 Policy conflicts - the fixed exchange rate may not be compatible with other
economic targets for growth, inflation and unemployment and this may cause
conflicts of policies. This is especially true if the exchange rate is fixed at a level
that is either too high or too low.

13.
Floating Exchange
Rate system

14.
A floating exchange rate is a country's exchange rate regime
where its currency is set by the foreign-exchange market
through supply and demand for that particular currency
relative to other currencies. Thus, floating exchange rates
change freely and are determined by trading in the forex
market.
Every currency area must decide what type of exchange rate
arrangement to maintain. Between permanently fixed and
completely flexible however, are heterogeneous approaches.
They have different implications for the extent to which
national authorities participate in foreign exchange markets.
Under a floating exchange rate system, market forces
generate changes in the value of the currency,
known as currency depreciation or appreciation.

15.
Advantages Of Floating Exchange
Rates
• Protection from external shocks - if the exchange rate is free to
float, then it can change in response to external shocks like oil price
rises. This should reduce the negative impact of any external
shocks.
• Lack of policy constraints - the government are free with a floating
exchange rate system to pursue the policies they feel are
appropriate for the domestic economy without worrying about
them conflicting with their external policy.
• Correction of balance of payments deficits - a floating exchange
rate can depreciate to compensate for a balance of payments
deficit. This will help restore the competitiveness of exports. There
is a link to Figure 1 below which illustrates the operation of the
automatic adjustment mechanism under a floating exchange rate
system.

16.
Disadvantages of floating
exchange rates
• Instability - floating exchange rates can be prone to large
fluctuations in value and this can cause uncertainty for firms.
Investment and trade may be adversely affected.
• No constraints on domestic policy - governments may be free
to pursue inappropriate domestic policies (e.g. excessively
expansionary policies) as the exchange rate will not act as a
constraint.
• Speculation - the existence of speculation can lead to
exchange rate changes that are unrelated to the underlying
pattern of trade. This will also cause instability and
uncertainty for firms and consumers.