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CHAPTER 8
BALANCE OF PAYMENTS

8.1 Definition of Balance of Payments(BOP) -

The BOP of a country is a systematic record of all economic transactions between its
residents and the residents of foreign countries during a given period of time

Residents of a country ordinarily include- individuals, business units, government and

their agencies

Economic transaction is an exchange of value. It is a process in which “there is transfer

of title to an economic good, the rendering of an economics service from residents of one
country to residents of other countries”
What is balance of payments? (Foreign 2011)

8.2 Structure of BOP accounting-

There are 2 types of transactions/economic activities that result in international

payments and receipts. They are-
1) Production and sale of current output – This results in export and imports of
goods and services currently produced
2) Purchase and sale of accumulated/ existing assets- These assets maybe real (for
e.g. plants, machineries) or financial (e.g.- shares)

There transactions are recorded using the double entry system of book keeping due to
which the debits must equal the amount of credits. Debit items are entered with a minus
sign and credit items with a plus sign.

All transactions are classified into 5 major categories-

1) Goods and services accounts
2) Unilateral transfers account
3) Long term capital account
4) Short term private capital account
5) Short term official capital account

BOP is divided into 2 major categories (2 sub accounts)

I) Current account
II) Capital account

8.3 Current account-

The current account records imports and exports of goods and services and unilateral
transfers.
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All exports of goods (steel, machinery, rice etc.) and services (banking, insurance,
tourism services to foreigners etc.) are entered as positive items in the account. This is
because exports cause an inflow of foreign exchange into the country
Imports are recorded as negative items in account because they cause an outflow of
foreign exchange from the country.

Components of current account-

The current account of BOP records imports and exports of goods and services and
unilateral transfers. Therefore it has 3 main components –

1) Export and Import Of Goods ( Visible Items) –

• The balance of exports and imports of goods is called the Balance of Visible
Trade because goods are visible to the eyes. It is also called as the Balance of
Trade.
• Balance of Visible Trade/ Balance of Trade is the difference between the
value of goods exported and value of goods imported.
• Balance of trade can be positive when value of exports is greater than value of
imports. There is straight surplus. Balance of trade is favorable.
• Balance of trade can also be negative when value of exports is less than value of
imports. There is trade deficit or unfavorable balance of trade.
• Balance of trade can be balanced when value of exports=value of imports.

2) Export and Import of Services (invisible items) –

• Services are known as invisibles because they are invisible to the eyes.
• Balance occurring on account of export and import of services is recorded as
balance of invisible trade
• They are classified into-
a) Services like travel, banking, transportation, tourism etc (non factor services)
b) Investment income i.e. rent, interest, dividends, profits
c) Compensation of employees
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3) Unilateral Transfers from one country to another –

• Balance occurring on account of payments and receipts of unilateral
transfers are called Balance of unilateral transfers/Unrequited transfers
• These transfers are one sided and include both private and government
transfers like gifts, donations, remittances, foreign aid etc.
• Receipts from abroad are entered as positive items and payments abroad are
entered as negative items.

Balance on Current accounts -

• The net value of- 1) Balance of visible trade 2) Invisible trade. 3) Unilateral
transferis known as the Balance on Current accounts.
• It is equal to the difference between the sum of credits and the sum of debits
on current account. It can be positive or negative
• A positive balance means that the credits are greater than debits on the current
account. It leads to an increase in the net asset position vis-à-vis the Rest of the
World.
• A negative balance also known as Credit Account Deficit (CAD) means that
debits are greater than credits on the current account. It leads to a decrease in the
net asset position vis-à-vis the Rest of the World.
• It canbe financed by-
a) Drawing on the gold stocks
b) Drawings on foreign exchange reserve
c) Mobilizing foreign exchange by way of investments and deposits
d) Borrowings

Understand Current Account Balance

the
difference Current Account Balance
between = Balance of Visible Trade
Current + Balance of Invisible Trade
Account + Balance of Unilateral Transfers
Balance and
Balance of Note:Balance of Trade or trade balance refers to the balance
Trade occurring on account of export and import of goods only
(Export and import of visible items only)

1) List the items of the current account of balance of payments account. Also define ‘balance
of trade’. (Delhi 2009, Delhi 2014)
2) List the type of transactions that are recorded in the current account of balance of
payments account. (Foreign 2009, AI 2011,Delhi 2015)
3) State the components of current account of balance of payments. (Delhi 2011, Foreign
2011, 2015)
4) Which transactions determine balance of trade? When is balance of trade in surplus? (AI
2011)
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8.4 Capital accounts-

Capital account records all such transactions between residents of a country and the rest
of the world which cause a change in the asset or liability status of the residents of the
country or its government.

It records inflow and outflow of foreign exchange on account of financial

transactions i.e. changes in foreign financial assets and foreign financial liabilities

Components of capital account- The capital account shows all inflows and outflows of
capital i.e. loans, deposits and investments.
Two Principle components of capital account BoP are:
1. Borrowing and
2. Foreign investment (expenditure on the ownership of assets abroad)
Borrowing is often split as:
(i) Commercial borrowings, referring to borrowing by a country (including
government and private sector) from international money market. This involves
market rate of interest without considerations of any concession,
(ii) Borrowings as External Assistance, referring to borrowing by a country with
considerations of assistance. It involves lower rate of interest compared to that
prevailing in open market. External assistance is available at the concessional rate
of interest.

Foreign investment is classified as:

i. Portfolio investment and

ii. Foreign direct investment
i.Portfolio investment- It involves purchasing of an asset but no control over it
for e.g. purchase of shares in a foreign country, purchase of bonds issued by
foreign government, loans made to foreign firms or government.(It basically
refers toFII-Foreign Institutional Investment)
ii.Foreign direct investment
It involves purchasing an asset and acquiring control of it.
Examples of such investments are: acquisition of a firm in one country by a firm
in another country like purchase of a firm by TATA in the rest of the world.
Transfer of funds from the parent company abroad to the subsidiary company in
the domestic country, purchase of household etc.

Other components of Capital Account

3. NRI Deposits:
Only deposits held by NRIs in the domestic economy are to be considered as a
component of capital account.
4. Banking capital(other than NRI Deposits)
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It refers to ‘foreign assets’ held by the commercial banks. Owing to drawdown of

foreign assets of the commercial banks(the commercial banks converting their
foreign assets into liquidity), inflow of freign exchange into the domestic
economy tends to rise.
5. Short-term Trade credit
It arises on account of purchases in the international market without making
immediate payment. Repayment of short term debt to rest of the world leads to
outflow of foreign exchange to rest of the world. It is recorded in capital account
with a negative sign. On the other hand, inflow will be recorded with a positive
sign.

Balance on Capital Account –

Capital Account Balance =

Inflow of foreign exchange on account of the sale of domestic assets or borrowingfrom
the rest of the world –(less)
Outflow of foreign exchange on account of the purchase of foreign assets or loans to the
rest of the world

Surplus on capital account implies net inflow of capital

Deficit on capital account implies net outflow of capital.

1) State the components of capital account of balance of payments. (Delhi 2011,Delhi 2015)
2) What does balance of payments account show? Name the 2 parts of the balance of
payments
8.5 Otheraccount.
items in(Delhi
BOP- 2011)

8.5.1 Errors and omissions –

BOP is prepared on the basis of double entry system. Therefore the sum of all credits
should equal sum of all debit. However errors and omissions can arise due to-

a) Incomplete information
b) Presence of sampling of transactions rather than recording each individual
transaction
c) Dishonesty or business men under reporting sales abroad to avoid taxes
d) Smuggling etc.
In order to balance the 2 sides errors and omissions are included in the BOP

8.5.2 Official Reserve Transactions-

• Official Reserve Transactions are carried out by the government and the
central banks in pursuit of some international economic policy objective.
• These transactions are not autonomous.
• Official reserve transactions have an impact on the BOP or on the exchange
rate. The items under these transactions are as follows-
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a) Change in the domestic country’s official reserve assets-

a) These reserves are held in the form of foreign currency or foreign currency
securities gold and Special Drawing Rights (SDR) with the IMF.
b) SDR allows the country to get foreign exchange in proportion to the quantity of
the country’s deposit of its currency with the IMF under the SDR scheme.
c) The change in country’s reserve will reflect the net value of all other items in the
BOP
d) Reductions in these assets are used to finance expenditures abroad. Reductions
appear as credit items in the BOP because their sale causes foreign exchange
inflow into the country
e) An increase in these reserves will appear as debit because purchasing assets will
cause outflow of foreign exchange

b) Change in foreign official assets in India-

a) Foreign central banks will hold part of their reserve assets in form of rupees.
b) In foreign central banks increase in this amount will appear as positive item
because their purchase of our rupee securities or rupees will cause inflow of
foreign exchange into India
c) A decrease in such reserve causes flow of foreign exchange out of the country
and is recorded as a negative item.

8.6 Distinguish between autonomous items and accommodating items-

Autonomous items Accommodating items

There are related to such transactions that
take place due to some economic motive
such as profit maximization
These are not conditioned by the BOP
status of the country which can be
positive or negative favorable or
unfavorable
These are not meant to establish BOP
identity
They are such transactions which are not
determined by the motive of profit
maximization. They occur because of the
activity in the BOP for e.g. government
financing
They are conditioned by the positive or
negative BOP status of the country
They are meant to restore the BOP
identity. BOP always balances because of
the accommodating items for e.g. incase
of deficit on current account occurring due
to autonomous items, the government of a
country may decide to restore BOP
identity by way of borrowing from the
IMF or world bank which would be an
accommodating item
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They are referred to as ‘Above The Line They are referred to as ‘Below The Line
Items’ Items’
Eg. Export import of consumer good or Eg. Borrowing from IMF to cover BOP
capital good deficit
Sale of financial assets by RBI to finance
deficit in BOP
Distinguish between autonomous and accommodating transactions of balance of payments
account. (2010, AI 2010, Foreign 2011,AI 2014,AI2017)

8.7 Disequilibrium in BOP-

Disequilibrium is a state of either deficit BOP status or surplus BOP status. Equilibrium
in BOP is achieved when the net balance of all receipts and payments is zero.
Explain the meaning of deficit in balance of payments. (Delhi 2010)

8.8 Difference between Balance of Trade and Balance of Payments-

Balance of trade BOP

BOT (positive or negative) is determined BOP (positive or negative) is determined
considering only visible items of considering all economic transactions i.e.-
transactions. It is different between export a) Visible items
of goods and import of good b) Invisible items
BOT= export of visible items- imports of c) Unilateral Transfers
visible items d) Capital transfers
It does not account for invisible items of
trade as well as capital transfers
It is a narrow term It offers a more comprehensive picture of
economic transactions of a country with
ROW.

8.9 Distinguish between Current Account and Capital Account-

CURRENT ACCOUNT CAPITAL ACCOUNT

1. It is a systematic record of import and
export of goods and services and
transfer receipts and
payments(unilateral payments)
2. Its components are import and export
of goods and services and unilateral
transfers.(Explain- refer notes)
3. Deficit in current account causes a
decrease in net asset position vis-a-vis
the rest of the world.
1.It records inflow and outflow of foreign
exchange on account of foreign financial
transactions i.e. change in foreign
financial assets and foreign financial
liabilities
2. Its components are private transactions,
official transactions, direct investment and
portfolio investment.(Explain- refer notes)
3. Deficit on capital account causes net
outflow of capital
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4. Surplus cause increase in the net asset 4. Surplus causes a net inflow of capital.
position vis-a-vis ROW.
5. Example - Import of machinery 5. Example - Investment in shares of a
foreign company

Distinguish between current account and capital account of balance of payments account.
(Foreign 2009, 2010, AI2017)

8.10 Distinguish between Balance of Trade and Balance on Current Account

BASIS BALANCE OF TRADE BALANCE ON

1. Meaning and It refers to the difference
Components between import and export
of visible goods
2. Scope It has a limited scope
CURRENT ACCOUNT
It refers to the difference
between import and export
of visible goods, invisible
items and unilateral
transfers
It has a wider scope

Distinguish between balance on trade account and balance on current account. (AI 2009, AI
2011, Foreign 2010, Foreign 2011)
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CHAPTER 9
FOREIGN EXCHANGE RATE

9.1 Meaning of Foreign Exchange Rate

9.2 Importance of Foreign Exchange
9.3 Foreign Exchange Market
9.4 Functions of Foreign Exchange Market
9.5 Factors for Demand of Foreign Exchange
9.6 Factors for Supply of Foreign Exchange
9.7 Determination of Equilibrium Foreign Exchange Rate
9.8 Appreciation/Depreciation and its effect on exports and imports
9.9 Disequilibrium Conditions: Impact of Change in Demand and Supply
9.10 Appreciation and Depreciation of the Domestic Currency
9.11 Types of Exchange Rate System
9.12 Managed Floating Rate

9.1 Meaning of Foreign Exchange Rate –

Foreign Exchange Rate refers to the price of one currency in terms of another.
Or
Foreign Exchange Rate refers to the rate at which one unit of currency of a country
can be exchanged for the number of units of currency of another country.

In other words, it is the price paid in domestic currency in order to get one unit of foreign
currency.

For example –
$ 1 = Rs 50.
Or
Rs1 = 1/50 Dollar = 2 Cents

It expresses the ratio of exchange between the currencies of two countries.

Define foreign exchange rate. (Delhi 2011, Foreign 2010)
Define foreign exchange. (AI 2011)

9.2 Importance of Foreign Exchange –

1) It is the rate at which the exports and imports of a nation are valued at a given
point in time
2) By linking the currencies of different countries it is possible to make comparisons
of international costs and prices
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3) It governs the flow and direction of foreign trade.

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9.3 Foreign Exchange Market –

It is the market where the national currencies are traded for another.

It is the centre of trade for different currencies. Buyers and sellers in foreign exchange
market wish to buy foreign exchange or sell foreign exchange

9.4 Functions of Foreign Exchange Market –

The foreign exchange market performs the following functions –

1) Transfer Function – It implies transfer of purchasing power in terms of

foreign exchange across different countries of the world
2) Credit Function – It implies provision of credit in terms of foreign
exchangefor the export and import of goods and services across different
countries of the world.
3) Hedging Function – It implies protection against the risks related to
variations in foreign exchange market. Demand for and supply of foreign
exchange is committed at some commonly agreed rate of exchange even when the
commitments are to be honored on some future date.

9.5 Factors for demand of Foreign Exchange –

Foreign exchange is demanded for the purpose of –

1) To purchase goods and services from other countries. It involves direct

purchases abroad as well as imports from the rest of the world.
2) Gifts and grants to the rest of the world.
3) Investment in the rest of the world. For example to purchase financial assets in
a particular country.
4) Payments of international loans
5) Speculative trading in foreign exchange by our residents.
6) Payment of factor incomes to abroad (Rent, interest, wages and Profit)

9.6 Factors for supply of Foreign Exchange –

Supply of foreign exchange depends on the following factors –

1) Exports of the country to the rest of the world

2) Direct purchases of goods and services by the foreigners in the domestic
market
3) Direct foreign investment
4) Remittances by the non residents living in foreign countries
5) Speculative purchases by the non residents in the domestic market
6) Loans from rest of the world
7) Grants and donations from rest of the world
8) Factor incomes from rest of the world
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1) Explain 2 sources each of demand and supply of foreign exchange. (Delhi 2009, AI 2009,
Foreign 2010, Foreign 2012)
2) Give the meaning of foreign exchange rate. Explain any 2 sources of supply of it.
(Foreign2009)
3) State two sources of supply of foreign exchange. (Delhi 2010)
4) State two sources of demand for foreign exchange. (AI 2010)

9.7 Determination of Equilibrium Foreign Exchange Rate –

The foreign exchange rate is determined by the demand and supply of foreign exchange.
Equilibrium exchange rate occurs where supply of and demand for exchange is equal to
each other.

The demand curve for foreign exchange is negatively sloped i.e. the exchange rate and
the demand for foreign exchange is inversely related. Less foreign exchange is
demanded as the exchange rate increases. This is because, as the exchange rate rises, it
makes imports expensive and therefore, imports decline resulting in a decline in the
demand for foreign exchange. Rise in the price of foreign exchange will increase the
rupee cost of foreign goods which makes them more expensive.

For example, if 1$ = 50 Rs changes and becomes

1$ = 75 Rs (rises)

Then for 1$ worth of imports, we have to pay 25 Rs more resulting in decline in imports.
On the other hand, the supply curve for foreign exchange is positively sloped i.e. the
exchange rate and the supply of foreign exchange are directly related. This is
because as the exchange rate rises, the exports become cheaper and therefore exports
increase resulting in an increase in the supply of foreign exchange. The home country’s
goods become cheaper to foreigners since rupee is depreciating in value. The demand for
our exports will increase which will lead to a greater supply of foreign exchange

For example, if 1$ = 50 Rs becomes

1$ = 75 Rs (rises)

Then the foreigners have to pay only 1$ to get 75 Rs worth of our goods. They get 25 Rs
more in terms of goods for the same amount resulting in increase in exports.

The equilibrium rate is determined by the intersection of the downward sloping

demand curve and the upward sloping supply curve as shown in the diagram below –
Diagram
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In the above diagram, supply and demand are measured on the OX axis, and the
exchange rate on the OY axis. DD is the demand curve and SS is the supply curve of the
foreign exchange. Both these curves intersect at point E. It is an equilibrium point. OR
is the equilibrium rate of exchange.

If the rate of exchange rises to OR1 then the supply of foreign currency will exceed its
demand. The rate of exchange will therefore come down to OR.

On the contrary, if the rate of exchange falls to OR2 then the demand for foreign
currency will be more than the supply. Rate of exchange will therefore again rise to
OR.

Rate of exchange will, therefore, be determined at a point where demand for and supply
of foreign exchange are equal.

9.8 Appreciation/Depreciation and its effect on exports and imports

APPRECIATION
When there is a decrease in the domestic
currency price of the foreign currency.
(decrease in exchange rate)
The domestic currency thus becomes more
valuable
For example: 1 US $ = 70 Rs becomes
1 US $ = 60 Rs
Effect on exports – Exports become expensive
DEPRECIATION
When there is an increase in the domestic
currency price of the foreign currency.
(Increase in exchange rate)
The domestic currency thus becomes less
valuable
For example: If 1US $ = Rs 60 becomes
1US $ = Rs 70
Effect on exports - Exports become cheaper

Exports will decrease Exports will increase

This will result in a decrease in supply of This will result in an increase in the supply of
foreign exchange foreign exchange
(exchange rate and the supply of foreign (exchange rate and the supply of foreign
exchange are directly related) exchange are directly related)

The home country’s goods become costlier to The home country’s goods become cheaper to
foreigners since rupee is appreciating in value foreigners since rupee is depreciating in value.

Foreigners have to pay only 1$ to get 60 Rs
worth of our goods. They get 10 Rs less in
terms of goods for the same amount resulting in
decrease in exports
Effect on imports - Imports become cheaper.
It will decrease the rupee cost of foreign goods
Foreigners have to pay only 1$ to get 70 Rs
worth of our goods. They get 10 Rs more in
terms of goods for the same amount resulting
in increase in exports.
Effect on imports - Imports become costly. It
will increase the rupee cost of foreign goods

Imports will increase Imports will decrease

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This will result in an increase in the demand This will result in an decrease in the demand
for foreign exchange. for foreign exchange.
(exchange rate and the demand for foreign (exchange rate and the demand for foreign
exchange is inversely related) exchange is inversely related)

For 1$ worth of imports, we have to pay 10 Rs

less resulting in an increase in imports.

1) How is foreign exchange rate determined in the market? (AI 2009)

2) Giving two examples explain the relation between the rise in price of a foreign currency and its
demand. (Delhi 2010)
3) Giving two examples explain the relation between the rise in the demand for a foreign currency
when its price falls. (AI 2010)
4) When price of a foreign currency rises, its demand falls. Explain why. (Delhi 2011)
5) When price of a foreign currency rises, its supply rises. Explain why. (Delhi 2011, Foreign 2011)
6) When price of a foreign currency falls, its demand rises. Explain why. (Foreign 2011, AI 2011)
7) When price of a foreign currency falls, the supply of that foreign currency also falls. Explain
why. (AI 2011)
9.9 Disequilibrium Conditions: Impact of Change in Demand and Supply –

1) Increase in Demand -

• An increase in demand for foreign currency, for example the US$, will shift the
demand curve to the right.
• Due to the shift in the demand curve to the right, exchange rate will rise from
OR to OR1.
• As a result more rupees will be required to buy 1$. This means that the Indian
Rupee is depreciating.
• Currency depreciation takes place when there is an increase in the domestic
currency price of the foreign currency.
• The domestic currency thus becomes less valuable.
• Decrease in demand will lead to opposite effect.
Diagram
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2) Increase in Supply –

• Increase in supply of foreign currency, for example the US$, will shift the supply
curve rightwards.
• Due to this shift in the supply curve to the right, exchange rate will fall from OR
to OR 1.
• As a result fewer rupees will be required to buy 1$.This means that the Indian
Rupee is appreciating.
• Currency appreciation takes place when there is a decrease in the domestic
currency price of the foreign currency.
• The domestic currency thus becomes more valuable.
Diagram

9.10 Appreciation and Depreciation of the Domestic Currency –

APPRECIATION DEPRECIATION
Currency appreciation takes place when Currency depreciation takes place when
there is a decrease in the domestic there is an increase in the domestic
currency price of the foreign currency. currency price of the foreign currency.

The domestic currency thus becomes
more valuable
For example: If US $ exchanges for Rs
38, instead of Rs 40 earlier, then the
domestic currency has shown
appreciation.
The domestic currency thus becomes less
valuable
For example: If US $ exchanges for Rs
40, instead of Rs 38 earlier, then the
domestic currency has shown
depreciation.

Devaluation takes place when there is an increase in the domestic currency price of
the foreign currency. Itis the official lowering of the currency by the government or
the central bank. It is does not take place due to market forces.

Devaluation Depreciation

Devaluation is the fall in the value of
domestic currency in relation to foreign
currency as planned by the government .
Devaluation occurs only in countries that
do not allow their exchange rate to float
This is undertaken by the government
with an intention or purpose. For example,
to increase exports of goods and services
from the country.
Distinguish between devaluation and depreciation of domestic currency. (Delhi 2010)
P a g e | 16
Currency depreciation takes place when
there is an increase in the domestic
currency price of the foreign currency
in a situation when exchange rate is
determined by the forces of demand
and supply in international market.
It occurs only in countries that allow their
exchange rate to float
It happens automatically without any
intention. For example, $1 =Rs65 changes
to $1= Rs67
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9.11 Types of Exchange Rate System –

Broadly, two types (systems) of exchange rate have evolved over time. They are

1) Fixed Exchange Rate System

2) Flexible Exchange Rate System

1) Fixed Exchange Rate System -

• It refers to the rate of exchange as fixed by the government.
• Historically, it has two important variants –
1. Gold Standard System of Exchange Rate
2. Bretton Woods System of Exchange Rate Or Adjustable Peg System of
Exchange
• Fixed exchange rate system was abandoned in 1977. It was replaced by Flexible
System of Exchange Rate.

Merits of Fixed Exchange Rate System –

1) Stability – It ensures stability in the international exchange market. It ensures that
major economic disturbances do not weaken the policies of the member countries.
Day to day fluctuations are avoided. It helps formulation of long term economic
policies, particularly related to exports and imports.
2) Encourages International Trade – Fixed exchange rate system implies low risk
and low uncertainty of future payments. Therefore it encourages international
trade.
3) Co-ordination of Macroeconomic Policies – It helps to co- ordinate
macroeconomic policies across different countries of the world. Long term
economic policies can be drawn in the area of international trade and bilateral
trade agreements.

Demerits of Fixed Exchange Rate System –

1) Huge International Reserves – This system requires huge international reserves
of gold. This is because different currencies are directly or indirectly convertible
into gold.
2) Restricted Movement of Capital – It restricts the movement of capital across
different parts of the world due to the huge back up of international reserves. As a
result international growth process suffers.
3) Rigidity in Resource Allocation – It is a rigid system of exchange. It imparts
rigidity to the allocation of resources particularly in the area of international trade.

2) Flexible Exchange Rate System -

• It is an extreme situation where there is no intervention by capital banks.
• Flexible Exchange rate is that rate which is determined by the demand for
and supply of different currencies in the foreign exchange market.
• In other words, it is determined by the market forces, like the price of any other
commodity.
• The exchange rate at which the demand for foreign currency is equal to its supply
is called ‘Par Rate of Exchange’.
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• It is flexible rate because it tends to change according to the changes in the

demand for and supply of different currencies in the foreign exchange market.

Merits of Flexible Exchange Rate System –

1) No Need for International Reserves – Flexible exchange rate system eliminate
the need for the countries to hold international reserves because the member
countries are no longer floating ‘convertible currencies’.
2) Optimum Resource Allocation – It enhances efficiency in resource allocation.
Accordingly, allocation of resources in the area of international trade, tends to
become optimum.
3) International Capital Movement -Flexible exchange rate system enhances
movement of capital across different countries of the world. This is because
member countries are no longer required to keep huge international reserves.

Demerits of Flexible Exchange Rate System –

1) Instability – It causes instability in the international money market. Exchange
rate tends to fluctuate like price of goods in the commodity market.
2) Difficulty in Drawing Long Term Policies – Instability in the foreign exchange
market causes instability in the area of international trade. It becomes difficult to
draw long term policies of exports and imports.
3) Difficulty in Macroeconomic Policies - Flexible exchange rate makes it difficult
to co- ordinate the macroeconomic policies. Day to day fluctuations in exchange
rate makes bi lateral trade a difficult exercise.

9.12 Managed Floating Rate

1) Exchange rates fluctuate from day to day. It varies with the changes in demand
and supply of foreign currencies. But managed floating is not controlled by the
market forces of demand and supply
2) It is controlled by the Central Bank of the country. The Central Bank tries to
influence the rate by entering the market as a bulk buyer or seller
3) When it finds the rate too high, it starts selling foreign exchange from its
reserve , there by dampening its rise
4) When it finds the rate too low it starts buying to raise the rate
5) The Central Bank does it in the interest of the importers and exporters
6) Managed Floating Rate is also called as Dirty Floating Rate
(Note – Buy low, Sell high)

(Board question AI 2017)

Explain distinction between the Flexible exchange rate and Managed
floating exchange rate.
Basis of Flexible exchange Managed floating exchange
difference rate rate
Meaning Flexible Exchange It is a system in which the
rate is that rate which central bank allows the
is determined by the exchange rate to be
 P a g e | 19

demand for and determined by market forces

supply of different but intervenes at times to
currencies in the influence the exchange rate
foreign exchange
market.
Name It is also known as Managed Floating Rate is
free exchange rate also called as Dirty Floating
system Rate

Fluctuations As it is determined by Comparatively less

demand and supply fluctuations as government
forces, it is more intervenes to ensure that the
prone to fluctuations. rate does not vary much
Central No intervention The Central Bank tries to
bank/Government influence the rate within the
intervention desired limits through sale
and purchase of foreign
exchange in the international
money market. When the
exchange rate is found to
be unfavorable the RBI
plans to sell the forex in the
international market. It
increases the supply of
forex, leading to fall in the
value in relation to
domestic currency.
Vice versa in case of
appreciation
Predictability of Unpredictable as the Comparatively more
trade exchange rate is predictable as the variation
flexible in nature in the exchange rates are
governed by the monetary
authority
Note: point number 3 can be written if separately write short note on managed floating
exchange rate is asked. Hence given in bold.
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1) Explain the meaning and 2 merits of fixed foreign exchange rate. (Delhi 2009)
2) Explain two merits each of flexible foreign exchange rate and fixed foreign exchange rate.
(AI 2009)
3) Explain 2 merits and 2 demerits of fixed foreign exchange rate. (Foreign 2009)
4) Give the meaning of managed floating exchange rate. (AI 2010, Delhi 2012)
5) What is fixed exchange rate? (AI 2012)
6) What is flexible exchange rate? (Foreign 2012)
7) Distinguish between fixed and flexible foreign exchange rate. (Foreign 2009, Foreign 2010,
AI 2010)