FOREIGN EXCHANGE AND BOP

I. Define the following:

a) Foreign exchange It refers to all currencies other than the domestic currency of
any given country.

Eg: India’s domestic currency is Rupees and other currencies such as Dollar, Yen
Pound, Euro, etc are foreign exchange.

b) Foreign exchange rate

It is defined as the number of units of the domestic currency that is exchanged for
the one unit of a foreign currency.

Eg: 75 Rupees is $1.

c) Fixed exchange rate

Refers to a system in which exchange rate for a currency is fixed by the

Government and the RBI, they are the monetary authorities. They determine the
rate of exchange for the $ and How many Rs is to the $.
Eg: Morocco and China

d) Flexible exchange rate

refers to a system in which the rate of exchange is determined by the free forces of
demand and supply of different currencies. There is no role of government or the
RBI in this system.

Eg; USA and UK

e) Managed floating exchange rate

This system is a hybrid of the above two systems. The free market forces of
demand and supply operate and determine the equilibrium price. However, the
Central Bank intervenes to keep the exchange rate as close to the equilibrium rate
as possible within a band of values.
Eg: Rs 75 =$1. The RBI intervene when the change is + or – 10%
India follows this system.
f) Balance of trade

It refers to the difference between the amounts of exports and imports of the visible
items (goods). It is a part of the current account and is also known as the balance of
Visible Trade.

Balance of trade=
VALUE OF EXPORTS of goods - VALUE OF IMPORTS of goods

g) Balance of payments
Balance of Payment is a systematic record of all economic transactions made
between residents of a country and the rest of the world during the period of one
financial year.

It includes all transactions in goods (visible items), services (invisible) and assets
(flow of capital)

it consists of two sub accounts, current account and capital account.

It is always in balance as outflow equals inflow through change in the stock of
foreign exchange which is maintained by the RBI.

h) Autonomous items of the BOP

It is referred to those items to those international economic transactions that take

place because of profit maximisation motives. These items are free of the BOP
account because they are carried out for economic reasons.

Eg: Imports and exports of services, investment, etc.

i) Accommodating items of the BOP

Refers to transactions that are undertaken to cover the gap in the BOP account such
as surplus or deficit. These items are dependent on the BOP account because they
are placed for the purpose of balancing it.

Eg: Error and omissions, foreign reserve accounts, etc.

j) Appreciation

Appreciation refers to increase in the value of a domestic currency. This implies

that fewer units of the domestic currency have to be given up to get one unit of
the foreign currency. Imports become cheaper and exports become expensive.

Eg: Rs 74= $1 changed to Rs 70=$1

k) Depreciation

Depreciation refers to the decline in the value of a currency based on market

factors like supply and demand. Here, more units of domestic currency have to be
given up to get one unit of foreign currency. Imports became expensive and
exports became cheaper.

Eg: Rs 70= $1 changed to Rs 75 = $1

l) Devaluation

Devaluation refers to the reduction in the value of domestic currency in terms of all
foreign currencies under the decisions of the government.

Eg: it happened in India in 1966 and 1991, Rs 22 = $1 which changed to Rs 32 =

$1

m) Revaluation

Revaluation refers to the increase in the value of domestic currency in terms of all
foreign currencies by the government.

II. Differentiate between:

a) Devaluation and depreciation

BASIS DEVALUATION DEPRECIATION

Definition Occurs when a country Known as the decline in

purposefully lowers the a value of a currency
value of its currency as based on market factors
 it applies to its like supply and
exchange rate with demand.
currencies from other
countries around the
world

Example Rs 22 = $1 which Rs 70= $1 changed to

changed to Rs 32 = $1 Rs 75 = $1

Occurrence in India 1966 and 1991 Ongoing in the current

year

Effect on Import and Imports became Imports became

Export expensive, decrease and expensive and decrease,
exports became cheaper exports became cheaper
overnight and increase gradually and increase

Role of RBI RBI was the deciding RBI has no role

authority

Role of Market No role Free market forces of

demand and supply
determine the new
exchange rate

Exchange rate system Occurs in a fixed rate Occurs in a flexible rate

system system

b) Revaluation and appreciation

BASIS REVALUATION APPRECIATION

Definition Revaluation refers to the Appreciation refers to
increase in the value of increase in the value of
 domestic currency in a domestic currency.
terms of all foreign
currencies by the
government.

Example Eg: Rs 74= $1 changed

to Rs 70=$1

Role of RBI RBI was the deciding RBI has no role

authority

Role of Market No role Free market forces of

demand and supply
determine the new
exchange rate

Effect on imports Imports become cheaper Imports become cheaper

and exports and increase whereas, and increase whereas,
exports become exports become
expensive and decrease expensive and decrease

Exchange rate Occurs in a fixed rate Occurs in a flexible rate

system system system

c) Autonomous and accommodating items of the BOP

BASIS AUTONOMOUS ACCOMMODATING

ITEMS ITEMS

Definition These items are free of These items are

the BOP acc as they are dependent on the BOP
carried out for economc account as they are
reasons placed for the purpose of
balancing the BOP
account
 Example Import and export of Errors and omissions and
foods and services, foreign exchange
investments, unilateral reserves account
transfers

Alternate name Above the line items Below the line items

Result Result of these Depends on whether

transactions may be + there is an inflow (+) or
or - outflow (-) of foreign
exchange, the foreign
exchange reserves will
either decrease or
increase

Change Change depending on Change depends on

economic factors items in the current and
capital account

d) BOT and BOP

BASIS BALANCE OF BALANCE OF

TRADE PAYMENT

Definition It refers to a difference It provides a systematic

between the amounts record of all economic
of exports and imports transactions between
of the visible items residents of a country
(goods). and the rest of the
world during the period
 of one financial year.

Items It includes only visible It includes visible and

items(goods). invisible items( goods
and services),unilateral
transfers, etc.

Account It is a part of the It consists of two sub

current account accounts- capital and
current.

Nature of transactions It doesn’t record It records capital

capital transactions transactions.

III. Explain the impact on foreign exchange rate when:

a) Demand for foreign exchange increases

An increase in demand for foreign exchange will lead to the demand curve
shifting towards the right side. As a result, the foreign exchange rate will rise
and the value of the currency demanded would increase while the domestic
currency will depreciate.
b) Supply of foreign exchange increases
Increase in the supply of foreign exchange would lead to the supply curve
shifting towards the right side. As a result, the foreign exchange rate will
decrease and the value of currency supplied would decrease and the
domestic currency will be appreciated.

IV. Explain the impact on imports and exports when:

a) Foreign exchange rate goes up (domestic currency depreciates)

 The domestic currency depreciates when the foreign exchange rate goes up.
This means that more rupees are paid in exchange for $1.for As a result
imports become expensive and exports become cheaper.

Eg: if the exchange rate is Rs 50 = $1, then a t-shirt priced at Rs 100 would
fetch $2 as an export. If the rate changes to Rs 100= $1, then the t-shirt
would fetch $1.

b) Foreign exchange rate goes down(domestic currency appreciates)

The domestic currency appreciates when the foreign exchange rate goes
down. This means that less rupees are paid in exchange for $1. As a result,
imports become cheaper and exports become expensive.

Eg: if the exchange rate is Rs 100 = $1, then a t-shirt priced at Rs 100 would
fetch $1 as an export. If the rate changes to Rs 50= $1, then the t-shirt would
fetch $2.

V. Explain the structure of the BOP. Why is it always in balance?

Balance of Payment is a systematic record of all economic transactions made

between residents of a country and the rest of the world during the period of one
financial year. It includes all transactions in goods (visible items), services
(invisible) and assets (flow of capital).

it consists of two sub accounts, current account and capital account.

The structure of BOP is as follows:

BASIS CREDIT (inflow of DEBIT (outflow of

foreign exchange) foreign exchange)
Current 1 Exports of goods Import of goods

Current 2 Exports of services Import of services

Current 3 Unilateral transfers from Unilateral transfer to

abroad abroad
Capital 1 (Direct) Investment by (direct) investment
foreigners abroad
Capital 2 (Portfolio) investment by
foreigners
Capital 3 Borrowings from IMF or
foreign govts.
Capital 4 Borrowings from
companies or individuals
Official reserves account Money comes in if the
sum of both- current and
capital acc is positive and
reserves increase
(portfoli0) investment
abroad
Lending to foreign govts
or repayment to IMF
Lending to companies or
individuals
Money goes out if the
sum of both- current and
capital acc is negative
and the reserves decrease

The BOP account is always in balance as outflow equals inflow through change in
the stock of foreign exchange which is maintained by the RBI.