Balance of PaymentsCBSE Syllabus Balance of payments account- meaning and components; balance of payments deficit-meaning ™ Foreign exchange rate— meaning of fixed and flexible rates and managed floating @ Determination of exchange rate in a free market214 Deca ee eg Balance of Payments INTRODUCTION So far we had just limited to a closed economy in which there are no linkages with the rest of the world in order to simplify our analysis and explain the basic macroeconomic mechanisms. In reality, most modern economies are open, An open economy is one which interacts with other countries through various channels. There are three ways in which these linkages are established. 1. Output Market: An economy can trade in goods and services with other countries. This widens choice in the sense that consumers and producers can choose between domestic and foreign goods. ‘The domestic country may sell goods to the rest of the world, These are called exports. The economy may also buy goods from the rest of the world. These are called imports. 2. Financial Market: Most often an economy can buy financial assets from other countries, This gives investors the opportunity to choose between domestic and foreign assets. Capital from foreign countries may also flow into the domestic country, or the domestic country may be exporting capital to foreign countries, These are called capital lows. 3. Labour Market: Firms can choose where to locate production and workers to choose where to work. There are various immigration laws which restrict the movement of labour between countries, Movement of goods has traditionally been seen as a substitute for the movement of labour. In this unit, we will focus on the first two linkages. Thus, an open economy is said to be one that trades with other nations in goods and services and most often, also in financial assets. Indians, for instance, can consume products which are produced around the world and some of the products from India are exported to other countries.Foreign trade, therefore, influences Indian aggregate demand in two ways. First, when Indians buy foreign goods, this spending (imports) escapes as a leakage from the circular flow of income decreasing aggregate demand. Second, our exports to foreigners enter as an injection into the circular flow, increasing aggregate demand for goods produced within the domestic economy. In this unit, we will discuss the meaning and components of the balance of payments (BoP) account, BoP records the transactions in goods, services and financial assets between residents of a country with the rest of the world. We will discuss this in detail under Section 5.1 and 5.2. Afer considering accounting of international transactions on the whole, we will discuss how a single transaction between two countries takes place. Although some national currencies have international acceptability, what is important in transactions between two countries is the currency in which the trade occurs. For instance, if Mr. Gopal, an Indian resident wants to buy a book published in America (an import of a good), he would need dollars to complete the transaction. If the price of the book is 20 dollars, he would need to know how much it would cost him in Indian rupees. That is, he will need to know the price of dollar in terms of rupees. Similarly, if Mr. Balram, another Indian resident wants to visit America on a vacation (an import of tourist services), he will have to pay in dollars for his stay there and will need 4,000 US dollars. He will need to know where to obtain the dollars from and at what price. His demand for dollars would constitute a demand for foreign exchange which would be supplied in the foreign exchange market — the market in which national currencies are traded for one another ‘The major participants in this market are commercial banks, foreign exchange brokers and other authorised dealers and the monetary authorities. ‘The price of one currency in terms of another currency is known as the foreign exchange rate or simply the exchange rate. For example, a rupee-dollar exchange rate 70/8 means that it costs 70 rupees to buy one dollar: ‘Thus, in the above examples, Mr. Gopal will need 1,400 rupees to get 20 dollars from the foreign exchange market Similarly, Mr. Balram will need 2,80,000 rupees to get 4,000 dollars. We will discuss this in detail under Section 5.3 and 5.4 We will also discuss the determination of foreign exchange rate under fixed, flexible and managed floating exchange rate systemseat ey pay Balance of Payments: Meaning a mponents Meaning of Balance of Payments Balance of Payments (BoP) is defined as the statement of accounts of a country’ inflows and outflows of foreign exchange in a fiscal year. (Foreign exchange or foreign currency refers to any currency ather than the domestic currency.) There are two main accounts in the BoP ~ the current account and the capital account. Current account is the record of trade in goods and services and transfer payments, whereas capital account records all international transactions of assets, eg. money, stocks, bonds, government debt, etc. Since itis difficule to record all international economic transactions accurately, therefore we have a third element of BoP (apart from the current and capital accounts) called errors and omissions which reflects this. Debit Side ‘Any international transaction which results in outflow of foreign exchange is recorded on the debit side in the balance of payments accounts (the current account and or capital account). It is given a negative sign. For example, payments for imports of goods and services, purchase of financial assets (e.g. shares, debentures, bonds, etc.) in a foreign country, etc. Top Tip Buying foreign goods (i.e. import) is expenditure from our country and it becomes the income of that foreign country. Hence, it isa debit item of the current account of balance of payments. Note that imports decrease the domestic demand for goods and services in our country.Credit Side Any international transaction which leads to inflow of foreign exchange is recorded on the credit side in the balance of payments accounts (the current account or the capital account). It is given a positive sign. For example, receipts on account of exports of goods and services, foreign investments, factor income earned from abroad, loans and grants from abroad, ete Top Tips + Selling of domestic goods to foreign nationals, ie, export, brings income to our country. Hence, itis @ credit iter of the current account of balance of payments. Note that exports add to the aggregate domestic demand for goods and services in our country. + Foreign investments lead to inflow of foreign exchange. Hence, itis recorded on the credit side of the capital account since itis an international transactions of assets. Note that foreign investments are divided into Foreign Direct Investment (FDI) and Portfolio investment. While FDI involves foreign investors taking a controlling and lasting stake in productive enterprises, portfolio investments represent holdings of minor equity (without management control) or debt through the stock markets by foreign investors for the purpose of earning return on investment. Current Account of BoP Current Account is the record of trade in goods and services and transfer payments. Components of the Current Account 1. Trade in goods: It includes (i) exports of goods and (ii) imports of goods. For example, export ot import of machinery. 2. Trade in services: Services trade includes both net factor income and net non-factor income transactions. (i) Net factor income: Net factor income includes net international earnings of factors of production (ike labour, land and capital). Examples + Net income from compensation of employeesFay + Net investment income, i.e., interest, profits and dividends on our assets abroad minus the Dee ee ee Cs income forcigners earn on assets they own in India. (ii) Net non-factor income: Net non-factor income is net sale of service products like shipping, banking, tourism, software services, ete. 3. Transfer payments: Foreign transfers are the receipts which the residents of a country get for ‘free’, without having to provide any goods or services in return. They consist of gifts, remittances and grants. They could be given by the government or by private citizens living abroad. r Current 1 Trade in Trade in ‘Transfer Goods Services Payments r 1 L 1 I Exports of Imports of ‘Net Factor Net Non-factor Gifis, Remittances Goods Goods Income Income and Grants Net Tocome from | [Shipping Banking Compensation of | | Insurance, Tourism Employees Software Services, exc Net Lavesement Income Chart 1: Components of Current Account of Balance of PaymentsBalance on Current Account Balance on Current Account has two components: (i) Balance of Trade or Trade Balance and (ii) Balance on Invisibles. 1. Balance of Trade (BoT)/Trade Balance: Ic is the difference between the value of exports and imports of goods of a country during a year. Balance of Trade (BoT) = Value of exports of goods — Value of imports of goods Top Tip Exports and imports of goods is also called visible trade. Export of goods is entered as a credit item in BoT as it leads to inflows of foreign exchange whereas import of goods is entered asa debit irem in BoT as it results in outflow of foreign exchange. & BoT'is said to be in balance when exports of goods are equal to the imports of goods. > Surplus BoT or Trade surplus will atise if the total value of country’s exports of merchandise (goods) is more than value of its imports of the merchandise during a year. > Deficit BoT or Trade deficit will arise if the total value of country’s imports of merchandise (goods) is more than value of its exports of the merchandise during a year. 2. Balance on Invisibles: Net invisibles is difference between the value of exports and imports of invisibles ofa country in a given period of time. Invisibles include services, transfers and flows of income. © Current account is in balance when receipts on current account are equal to the payments on the current account.Cig Pe ay 217 © Current Accounz Surplus (CAS) refers to excess of receipts from value of export of visible items, invisible items and unilateral transfers over payments for value of import of visible items, invisible items and unilateral transfers. CAS is relatively broader concept as compared to trade surplus. CAS signifies chat the nation is a lender to the rest of the world. > Gurrent Account Deficit (CAD) atises when the value of exports of visible items, invisible items and unilateral cransfers is less than the value of imports of visible items, invisible items and unilateral transfers. CAD is relatively broader concept as compared to trade deficit. CAD signifies that the nation is a borrower from the rest of the world. Top Tip Difference between Balance on Trade Account and Balance on Current Account © ‘Balance on Trade Account’ is the difference between value of exports of goods and imports of goods. In ather words, itis the difference between visible inflow and visible outflows of foreign exchange. © ‘Balance on Current Account’ is the sum total of balance of trade and balance on invisibles. In other words, itis the difference between the sum of both visibles and invisibles inflows and outfiows of foreign exchange. Capital Account of BoP Capital account records all international transactions of assets. An asset is any one of the forms in which wealth can be held, for example, money; stocks, bonds, government debt, etc. > Capital inflows such as receipt of loans from abroad, sale of assets or sharcs in foreign companies, etc. are recorded on the credit side of the capital account as there is inflow of foreign exchange in India. Capital outflows such as repayment of loans, purchase of assets or shares in foreign countries, etc. are recorded on the debit side of the capital account as it results in outflow of foreign exchange.Components of Capital Account ‘There are three components of the capital account—Forcign Investments, External Borrowings and External Assistance. 1. Foreign Investments: Foreign investments may be of two kinds: (a) Direct Investment, og, Forcign Dircct Investments (FDIs), Equity Capital, Reinvested Earnings and other Direct Capital Flows. (b) Poréfolio Investment, e.g. Foreign Institutional Investments (FIIs), Offshore Funds, ctc. 2. External Borrowings: Examples: External Commercial Borrowings, Short-term Debt, etc 3. External Assistance: Examples: Government Aid, Intet-governmental, Multilateral and Bilateral Loans. Td aeer"_””C—EE1 Foreign External Investments Assistance Direct Portfolio Investment Investment I I ‘Examples: ‘Examples: Examples FDI, Equity Capical, FII, Offshore Funds Excernal Commercial Reinvested Barnings and Borrowings Shorter gxvernmental Mulilaeral and cocher Direct Capital Flows Debr Bilateral Loans Chart 2: Components of Capital Account of Balance of Payments218 Dnt ee Lrg Balance on Capital Account Balance on Capital Account is the sum toul of net foreign investments, net external borrowings and net extemal assistance. > Capital account is in balance when capital inflows (like receipt of loans from abroad, sale of assets or shares in foreign companies) are equal to capital outflows (like repayment of loans, purchase of assets of shares in foreign countties).. > Surplus in capital account arises when capital inflows are greater than capital outflows. > Deficit in capital account arises when capital inflows are lesser than capital outflows. If the value of exports of goods of a country is 1,000 croze and the value of imports of goods is 21,650 crore, calculate the trade balance of the country. (1 mark) Solution: Trade balance or Balance of trade = Value of exports of goods ~ Value of imports of goods = 1,000 = 1,650 = ()2650 crore Thus, there is a trade deficic of 2650 crore. yy Sees If the value of exports of merchandise of a country is €800 crore and the value of imports of merchandise is €650 crore, calculate the trade balance of the country. Ans. Trade surplus of 2150 crore] (1 mark)If the balance of trade of a country is showing a deficit of 2400 crore and the value of imports of goods is 21,100 crore, then what is the value of exports of goods? (1 mark) Solutions Trade balance or Balance of trade = Value of exports of goods ~ Value of imports of goods Since there is trade deficit of 8400 crore, trade balance = (~) 2400 crore and value of imports of goods = %1,100 crore, therefore, (-) 2400 crore = Value of exports of goods ~ 21,100 crore Value of exports of goods = - 400 + 1,100 = 2700 crore Peed If a country has trade surplus of 2200 crore and the value of exports of goods is 700 crore, then what is the value ofimports of goods? —_[Ans. 500 crore] (1 mark)Autonomous and Accommodating Transactions — Deficit or Surplus in Balance of Payments The tansactions recorded in the balance of payments accounts can be categorised as autonomous transactions and accommodating transactions. ‘TABLE 5.1: The balance of payments of a hypothetical economy, 2019-20 Autonomous transactions (above the line items) Ttems (in Million USD) Exports of goods Imports of goods ‘Trade Balance (2-1) (Net) Invisibles (4a + 4b + 4¢) a, Non-factor Services b. Tnoome Transfers 5. Current Account Balance (3+4) 6 Capital Account Balance (6a + 6b + 6c) a, Foreign investments (net) i, FDI (neo) 4i, Portfolio Investments (neo) ii, Other Direct Capital Flows b, External Borrowings (net) i, External Commercial Borrowings (net) ii, Short-term Debt c. External Assistance (net) 7. Encors and Omissions SME Na TA) REPS 300 700 (-) 400 Trade Deficit (60 40 (150 50 (460. Current Account Deficit 360. Surplus on Capital Account 160 100 50 10 180 60 120 20 10 ‘Accommodating transactions (below the line items) 9. Official Reserve Sale (ST ‘90 Decrease in official reservesUC ta Top Tip The balance of payments accounts presented above divide the transactions into two accounts, current account and capital account. However, following the new accounting standards introduced by the International Monetary Fund in the sixth edition of the Balance of Payments and international Invest ment Position Manual (BPM6) the Reserve Bank of India also made changes in the structure of balance of payments accounts. According to the new classification, the transactions are divided into three accounts: current account, financial account and capital account. The most important change is that, almost all the transactions arising on account of trade in financial assets such as bonds and equity shares are now placed in the financial account. However, RBI continues to publish the balance of payments accounts as per the old system also, therefore the details of the new system are not being given here Autonomous transactions — cause BoP deficit (or surplus) Autonomous transactions are the balance of payments transactions which are undertaken for some economic motives such as profit maximisation. These items are also called ‘zbove the line’ items in the BoP. Significance Autonomous transactions cause imbalance in BoP. A deficit or surplus in BoP cquals deficit or surplus in autonomous transactions only. > The balance of payments is in deficit if autonomous foreign exchange receipts are less than autonomous foreign exchange payments. > The balance of payments is in surplus if autonomous forcign exchange receipts are greater than autonomous foreign exchange payments. Thus, autonomous transactions are international economic transactions made due to some reason other than to bridge the gap in the balance of payments, i.e. these transactions are independent of the state of country’s BoP.Accommodating transactions — to cover BoP deficit (or surplus) Accommodating transactions are the balance of payments transactions which are determined by the gap in the balance of payments, i.e. whether there is a deficit or surplus in the balance of payments. dn other words, they are determined by the net consequences of the autonomous transactions. ‘These items are termed ‘below the line’ items in the BoP. Significance Accommodating transactions are influcnced by the state of country’s BoP. The significance of accommodating transactions is that they are undertaken to cover deficit (or surplus) in balance of payments. Jn other words, accommodating transactions restore balance in BoP. Official Reserve Transactions — to finance BoP deficit or utilise BoP surplus Official reserve transactions are the transactions carried on by monetary authorities of a country, which causes changes in official reserves. Importance Autonomous receipts and autonomous payments give rise to either deficit or surplus on Balance of Payments. The balance of payments is in deficit (surplus) if autonomous foreign exchange receipts arc less (greater) than autonomous foreign exchange payments. > ‘The country can use its reserves of foreign exchange in order to balance any deficit in its balance of payments. The Reserve Bank of India (RBI) sells foreign exchange in the foreign exchange market when there is a deficit in balance of payments. This is called ‘official reserve sale’. Jv other words, the Central Bank may finance a deficit in balance of payments by reducing reserves of forcign currency. This will be shown as decrease in official reserves of foreign currency. > The Central Bank may use surplus of balance of payments to purchase forcign securities, foreign currency, gold etc. which may result in increase in reserves of the nation.Thus, the decrease (increase) in official reserves is called the overall balance of payments deficit Gourplus). ‘The basic premise is that the monetary authorities are the ultimate financiers of any deficit in the balance of payments (or the recipients of any surplus) Top Tip * Since the official reserve transactions are made to bridge the gap in the BoP, they are seen s the accommodating transactions in the BoP. * Official reserve transactions are more relevant under a regime of fixed exchange rates than when exchange rates are floating, (See sub heading ‘Fixed Exchange Rates’ under section 5.3) How is Current Account Deficit (CAD) financed? A country that has a deficit in its current account must finance it: (by selling assets, eg. sale of shares in forcign companies etc. or (il) by borrowing abroad. ‘Thus, any currenc account deficic must be financed by a capital account surplus, that is, a net capital inflow so that: Balance on Current account + Balance on Capital account = In this case, a country is said to be in balance of payments equilibrium. The current account deficit is financed entirely by net capital inflows without any official reserve change/movements Pe P Surplus Pee Overall Balance Negative (<0) Positive (> 0) Zero (=0) Official Reserve Change | Decrease in official | Increase in official reserves of | Oficial reserve change = 0 reserves (ie. official | foreign exchange (i.e. no reserve move- reserve sale) ments)230 CL Foreign Exchange Rate — Fixed and Flexible Rates and. Managed Floating Foreign exchange or foreign currency refers to any currency other than the domestic currency. ‘The marker in which national currencies are traded for one another is known as the foreign exchange market. ‘The major participants in the foreign exchange marker are commercial banks, foreign exchange brokers and other authorised dealers and monetary authorities. Ic is important to note that although participants themselves may have their own trading centres , the market itself is world-wide, There is a close and continuous contact between the trading centres and the participants deal in more than one market. Foreign Exchange Rate Foreign Exchange Rate (also called 'Forex Rate’) is the price of one cutrency in terms of another. Ie links the currencies of different countries and enables comparison of international costs and prices. For example, if we have to pay 70 rupces for one dollar, then the exchange rate is 70/S. Forcign exchange rate is the rate at which one currency can be converted into another currency. Different countries have different methods of determining their currency’s exchange rate. Tt can be determined through Flexible Exchange Rate, Fixed Exchange Rate or Managed Floating Exchange Rate. Flexible (or Floating) Exchange Rates An exchange rate determined by the forces of demand and supply in the foreign exchange marker is flexible or floating exchange rate. In a completely flexible exchange rate system (i.e. clean floating), the central banks do not intervene in the foreign exchange marker. A central bank does not maintain any reserves of foreign currency as the market automatically adjusts to determine the market driven exchange rate. Therefore, there are no official reserve transactions.Determination of exchange rate in foreign exchange market Ina free market without central bank intervention, the equilibrium exchange rate is determined by the market forces of demand and supply of foreign exchange. Equilibrium exchange rate is the rate at which market demand and supply of foreign exchange are equal. [As depicted in Fig, 5.1, the equilibrium exchange rate is e* @70/$), which is determined by the intersection of demand and supply curves of forcign exchange US Dollars). Point q on the xaxis determines the quantity of dollars that have been demanded and supplied on c* exchange rate 7018). ‘Demand for Foreign Exchange in the foreign exchange market People demand foreign exchange because of the following reasons. These are sources of demand because these lead to ourflow of foreign exchange. (i) Imports: Importers need foreign exchange for making, payments for buying goods and services from abroad. < i = a & (ii) Foreign transfer payments: For cransfer payments to any other country in the form of gifts, grants or remittances, etc. foreign currency is needed. % (ii) Investments abroad: For investment in other Amount of Forelgn Exchange () countries, eg. purchase of financial assets like shares, bonds, etc. abroad, foreign currency is needed. Fig, 5.1. Determination of Exchange Rate in a Free Market(iv) (wy) Uni Cee ued FEST Tourism abroad: Forcign currency is nceded for forcign travel, for example, Indian people visiting abroad ona vacation say, for sight-seeing etc. Foreign exchange speculation: Another reason for the demand for forcign exchange is for speculative purposes. Foreign exchange is demanded for the possible gains from appreciation of the foreign currency. If speculators believe that the British pound is going to increase in value relative to the rupee, they will want to hold pounds. For instance, if the current exchange rate is €90/E and investors believe that the pound is going to appreciate by the end of the month and will be worth 295 (i.e., exchange rate will rise to 295/£), investors think if they took £90000 and bought 1000 pounds, at the end of the month, they would be able co exchange the pounds for € 95000, dhus making a profic of £5000. This expectation would increase the demand for pounds in the foreign exchange market. Demand curve of foreign exchange is downward sloping. Why? Demand curve of foreign exchange is downward sloping because of inverse/negative relationship between foreign exchange rate and demand for foreign exchange. A rise in price of foreign exchange causes decrease in demand for foreign exchange and vice-versa. Explanation: A rise in price of foreign exchange will increase the cost (in terms of rupees) of purchasing a forcign good. For example, if rupce-dollar exchange rate rises from & 70/$ to X 75/S, Indians have to pay more rupees to import US goods. This reduces demand for imports of foreign goods (US goods). This results in less oucflow of foreign exchange from India. Therefore, demand for forcign exchange (Dollars) decreases, other things remaining constant.Sources of supply of foreign exchange in the foreign exchange market Foreign currency flows into the home country due to the following reasons. These ave sources of supply because these lead to inflow of foreign exchange. (i) Exports: All exports of goods and services by domestic residents bring foreiga exchange into the county. Gi) Foreign Investments: Foreign Direct Investment (PDI), Portfolio Investments, e.g. Foreign Institutional Investment (FIl) add to the supply of foreign exchange as these bring in foreign exchange into the country. (iii) Foreign tourism: Foreign courists coming to India, say to visit Vrindavan bring foreign currency into the country. (iv) Other sources of supply of foreign exchange: Factor income earned from abroad, Remittances from abroad, g, NRIs send gifts or make uansfers, Loans and grants from abroad, Interest received on loans to abroad, ctc. ate also received in forcign currency. Supply curve of foreign exchange is upward sloping. Why? Supply curve of foreign exchange is upward sloping because of direc positive relationship between foreign exchange rate and demand for foreign exchange. A rise in price of foreiga exchange causes increase in supply of foreign exchange and vice-versa. Explanation: A rise in price of foreign exchange will reduce the foreigners’ cost (in terms of foreign currency) while purchasing goods from India, other things remaining constant, For example, if rupee-dollar exchange rate rises from % 70/$ to % 75/S, US dollars can now buy more of domestic goods. That is, exported goods become cheaper in the international market giving a competitive edge for the goods of domestic country (India). As exported goods become cheaper, this increases exports of India. This results in more inflow of foreign exchange. Therefore, supply of forcign exchange (Dollars) increases, other things remaining constant. Top Tip Link between the balance of payments accounts and the transactions in the foreign exchange market: Outflow of foreign exchange on account of imports of goods and services, investments made abroad, etc. (total debits in ‘the BoP accounts) represent the demand for foreign exchange in the foreign exchange market. Conversely, total credits in the BoP accounts, eg, inflow of foreign exchange forall exports of goods and services, external borrowings, foreign investments, etc. represent the supply of foreign exchange in the foreign exchange market.Fry] a s XIl - by Subhash Dey Fixed Exchange Rates ‘Under fixed exchange rate system, che Government fixes che exchange rate at a particular level. The Centeal Bank actively uses its foreign exchange reserves to maintain the officially determined exchange rate. ‘An exchange rate between the two currencies fixed at government level is called fixed exchange rate. Jn Fig. 5.2 the market determined exchange rate is *e (&70/$). However, let us suppose that for some reason the Indian Government wants to encourage exports for which ic needs 10 make rupee cheaper for foreigners i would do so by fixinga higher exchange rate, say €75 per dollar from the current exchange rate of 270 per dollar. Thus, the new exchange rate set by the Government is e, where @, > &. ‘At this exchange rate, the supply of dollars exceeds the demand for dollars. The RBI intervenes to purchase the dollars for rupees in the foreign exchange market in order to absorb this excess supply which has been marked as AB inn the figure. Thus, through intervention, the Government can maintain any exchange rate in the economy. But it will be accumulating more and more forcign exchange so Jong as this intervention goes on, On the other hand, if the government was to set an exchange rate at a level such as ¢,, there would be an excess demand for dollars in the foreign exchange market. To meet this excess demand for dollars, the government would have ro ‘withdraw dollars from ts past holdings of dollars. Fit fils to do so, a black marke for dollars may come up. < ‘The Exchange Rte (Rupees!) ‘Amount of Foreign Exchange (8) Fig. 5.2 Maintaining Official Exchange Rate by RBI Top Tip (Official reserve transactions are more relevant under a regime of fied exchange rates than when exchange rates are floating.Devaluation of domestic currency In a fixed exchange rate system, when the government increases the exchange rate (thereby, making domestic currency cheaper in terms of a foreign currency) is called Devaluation of domestic currency. In other words, devaluation of domestic currency is reduction in the value of domestic currency by the government with respect to a given foreign currency. Revaluation of domestic currency In a fixed exchange rate system, when the government decreases the exchange rate (thereby, making domestic currency costlier in terms of a foreign currency) is called Revaluation of domestic currency. Managed Floating Exchange Rates Without any formal international agreement, the world has moved on to what can be best described as a managed floating exchange rate system. In a system of managed floating exchange rates, the exchange rate is determined by the combined forces of demand and supply of foreign exchange, but the Central Bank may intervene to buy or sell foreign currencies in order to control the exchange rate fluctuations. Official reserve transactions are, therefore, not equal to zero. Managed floating exchange rate is the floating (or flexible) exchange rate which can be influenced by the intervention of the Central Bank in the foreign exchange market. Thus, managed floating exchange rate system is the amalgamation of the flexible exchange rate system and the fixed exchange rate system because managed floating exchange rate is decided by market forces (the float part) bur remains within a specific range as decided by central bank (the managed part). Top Tip Managed floating exchange rate system is also called ‘dirty floating’ as the clean floating rate is influenced by the intervention of the Central Bank in the foreign exchange market.Exchange Rate in a Free Market: Effects of Change in SBYSE NRT bg Effects of Increase in Demand for Foreign Exchange Increase in demand for foreign exchange may be due co the following reasons: (iRise in imports of forcign goods and scrvices, for example, due to increased international travelling by Indians, (ii) Purchasing more financial assets abroad, (iii) Increase in demand for foreign exchange for speculative purposes, (iv) Increase in transfer payments to foreign countries, etc. Effect on the exchange rate > Due to increase in demand for foreign exchange, the demand curve shirts upward and right to the original demand curve. Supply of foreign exchange remaining same, increase in demand will cause excess demand of foreign currency at the prevailing foreign exchange rate. > As a result, a new equilibrium rate of forcign exchange rate will be determined which will be higher than the prevailing foreign exchange rate. > Thus, there will be a rise in the forcign exchange rate (say from e* = & 70/$ to ¢, = & 75/8), other things remaining unchanged. Armour ot Fran Exchange) } Rise in the price of foreign exchange, say &70/$ to we impli Co oa COM Fig. 5.3 Effect of Increasein Demand for Foreign Exchange rupees). < > v ‘The Exchange Rate (Rupeesi) %Depreciation is the fall in the value of domestic currency in relation to a foreign currency caused by rise in foreign exchange rate in the foreign exchange market under the flexible exchange rate system. Depreciation of rupee indicates that the value of rupees in terms of dollars has fallen. Clearly, a rise in exchange rate from %70/$ to 275/$ means that we need t© pay more rupees for a dollar now. Effect of depreciation of domestic currency on exports and imports Depreciation of domestic currency (rupees) normally increases exports from a country, as exports become cheaper for the foreign nationals and foreign currency can now buy more of domestic goods, i.c., the international competitiveness of the goods and services of the nation gets better. On the other hand, Depreciation of domestic currency (rupees) will increase the cost (in terms of rupees) of purchasing a foreign good. Indians will have to pay more rupees to import foreign goods, This reduces demand for imports of foreign goods. Thus, imports fall. Effect o1 Since exports rise and imports fall, therefore, Net Exports (= Exports - Imports) will increase. An inerease in Net Exports will increase the national income, other things remaining unchanged. national income Top Tip 1. Effects of decrease in demand for foreign exchange Due to decrease in demand for foreign exchange, the demand curve shifts leftwards to the original demand curve. Supply of foreign exchange remaining same, decrease in demand will cause excess supply of foreign currency at the prevailing foreign exchange rate. As a result, a new equilibrium rate of foreign exchange rate will be determined which will be lower than the prevailing foreign exchange rate. Thus, foreign exchange rate is likely to fal, leading to appreciation of domestic currency. (Appreciation will be discussed next.) 2. Depreciation of domestic currency implies appreciation of the foreign currency.Effects of Increase in Supply for Foreign Exchange Increase in supply for foreign exchange may be due to the following reasons: (Rise in exports of goods and services, (ii) Increase in forcign investments (c.g. Forcign Direct Investment, Portfolio Investments, ctc.), (iii) More foreign tourists coming to India, ete. Effect on the exchange rate > Due to increase in supply of foreign exchange, the supply curve shifts rightwards to the original supply curve. v Demand for foreign exchange remaining same, increase in supply will cause excess supply of foreign currency at the prevailing foreign exchange race, » As a result, a new equilibrium rate of foreign exchange rate will be determined which will be lower than the prevailing foreign exchange rate. > Thus, there will be a fall in the foreign exchange rate (say from ef = X70/$ to €, = 268/$), other things remaining unchanged. Amount of foreign exchange (§) > Fallin the price of foreign exchange, say %70/$ to 268/$ implies ‘appreciation’ of domestic currency (rupees). Ina flexible exchange rate system, when the price of foreign currency (say; dollars) in terms of domestic currency (rupees) falls, the value of domestic currency in terms of forcign currency increases, it is called appreciation of domestic currency. | i i i 2 Lie eel cheba Acadia) aakeacob a Appreciation of domestic currency means that we need to pay fewer rupees in exchange for one dollar. For example, a fall in the exchange rate (say, fiom %70/$ to %68/S) indicates that the value of rupee relative vo dollar has increased since we need to pay only 68 rupees in exchange for one dollar.Effect of appreciation of domestic currency on exports and imports Appreciation of domestic currency decreases exports since domestic goods become costlicr for the foreign nationals. This is so because one unit of foreign currency can now buy less of domestic goods, i.e. the international competitiveness of the goods and services of the nation gets worse. On the other hand, due to appreciation of domestic currency, the importers have now to pay less domestic currency to import one unit worth of foreign currency goods. Imports thus become cheaper. This raises demand for imports. Effect on national income Since exports decrease and imports increase, therefore, Net Exports (= Exports — Imports) will decrease. A decrease in Net Exports will decrease the national income, other things remaining unchanged. Top Tip 1. Effects of decrease in supply of foreign exchange Due to decrease in supply of foreign exchange, the supply curve shifts leftwards to the original supply curve. Demand for fo ‘exchange remaining same, decrease in supply will cause excess demand of foreign currency at the prevailing foreign exchange rate. As a result, a new equilibrium rate of foreign exchange rate will be determined which will be higher than the prevailing foreign exchange rate. Thus, foreign exchange rate is likely to rise, lea to depreciation of domestic currency. 2. ‘Appreciation of domestic currency implies depreciation of foreign currency.