28-11-2023

Errol D’Souza

Balance of Payments & Exchange Rates Balance of Payments

Errol D’Souza This is an accounting record of the market value
of goods, services, and financial assets
that domestic residents exchange with
foreigners from other nations during an
accounting period.

There are three balance of payments concepts -

• Current Account balance

• Capital Account balance

• Overall balance

Email: errol@iima.ac.in 2

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Errol D’Souza Errol D’Souza

(US Dollars Billion) 2020-21

The accounting of the balance of payments is
Exports 296.30
stated as follows -
Current Account Balance = CA Agriculture 33.17
Capital Account Balance = KA Gems & Jewellery 26.02
Overall Balance = (CA + KA) Drugs & Pharma Products 24.44
Official Reserves, R = - (CA + KA) Engineering Goods 76.73
Textiles & Carpets 29.47
The Overall balance is financed by monetary author-
ities who absorb the finance required for overall Petroleum, Plastics & Linoleum 33.25 (78% petroleum)
balance by accumulating foreign exchange Imports 398.45
Pearls, precious
reserves or provide foreign exchange reserves
Petrol, Crude & Products 82.68 & semi-precious
when the overall balance is in deficit. stones: 18.89
Coal, Coke & Briquettes etc. 16.28
To understand this role of monetary authorities we
need to understand how the exchange rate3is Organic & Inorganic chemicals & products 28.27 Gold & Silver:
determined. Machinery & Transport equipment 49.67 35.39

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Errol D’Souza Errol D’Souza

(US Dollars Billion) Year → (US Dollars Billion) Year → 2020-21

2020-21

Trade Balance Current Account Balance 23.92

-102.15
Invisibles (Net) Foreign Investment (net) 80.10
126.07
Foreign Travel -3.02 (a) FDI 43.96

Transport 2.10 (b) Portfolio Investment 36.14

Insurance Loans (ECBs & Banking Capital) -16.64

0.32
-41.37 NRI deposits 7.36
Investment Income Comp of Employees
= 3.19
Total Capital Account Balance 63.37
Private Transfers 73.32
Overall Balance 87.29
Telecom Computer & Information Services 90.80
Monetary Movements 87.29
Current Account Balance 23.92 (a) IMF (net) 0
(b) Foreign Exchange Reserves [(-),(+)] -87.29

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Errol D’Souza Errol D’Souza

Figure 2.2: Exchange Rate and Balance of Payments

Exchange Rate E Rs./$

Importers - DM
Current Account
Exporters - SX

Import of Capital
Capital Inflows - MK
Capital Account

Export of Capital
Capital Outflows - XK

Rupees Flow of
Exchange Rate = $ Dollars
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Errol D’Souza Errol D’Souza

Figure 2.2: Exchange Rate and Balance of Payments Figure 2.2: Exchange Rate and Balance of Payments
Exchange Rate E Rs./$ Exchange Rate E Rs./$

DM DM SX
Importers demand
for dollars
Exporters supply
of dollars

Flow of Flow of
Dollars Dollars
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Errol D’Souza Errol D’Souza

Figure 2.2: Exchange Rate and Balance of Payments Figure 2.2: Exchange Rate and Balance of Payments
Exchange Rate E Rs./$ Exchange Rate E Rs./$

DM SX DM DM+XK SX
SX+MK SX+MK

Demand for dollars

Supply of dollars
from capital
from capital
outflows, XK.
inflows, MK.

Flow of Flow of
Dollars Dollars
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Errol D’Souza Errol D’Souza

Figure 2.2: Exchange Rate and Balance of Payments Figure 2.2: Exchange Rate and Balance of Payments
Exchange Rate E Rs./$ Exchange Rate E Rs./$

DM DM+XK SX DM DM+XK SX
SX+MK SX+MK
E
Equilibrium exchange Exchange rate
E rate E fixed at E
DM + XK = SX + MK

Flow of A C Flow of
Dollars Dollars
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AC = Current Account surplus/deficit 14

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Errol D’Souza Errol D’Souza

Figure 2.2: Exchange Rate and Balance of Payments Figure 2.2: Exchange Rate and Balance of Payments
Exchange Rate E Rs./$ Exchange Rate E Rs./$

DM DM+XK SX DM DM+XK SX
SX+MK SX+MK
E E
AC = Current Account
surplus/deficit
E E CD – AB = capital account
surplus/deficit

E E

A B C D Flow of A B C D Flow of
XK = Capital MK = Capital Dollars Dollars
outflows inflows AC + (CD – AB) = Overall
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CD – AB = capital account surplus/deficit surplus/deficit

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Errol D’Souza Errol D’Souza

Figure 2.2: Exchange Rate and Balance of Payments

Exchange Rate E Rs./$

DM+XK SX Benefit of Intervention in Exchange Rate market -

DM
SX+MK
E Exchange rate does not appreciate

E Note that exchange

rate is prevented Cost ?
from appreciating
by accumulating
E
forex reserves

A B C D Flow of
Dollars
Accumulation of 17 18
forex reserves

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Errol D’Souza Errol D’Souza

To avoid this cost of increased liquidity what can

Simplified Central Bank Balance Sheet
the monetary authority do?
Assets Liabilities
It can sterilize the liquidity impact of the capital flow.
Central Bank credit Currency in circulation
to government Sterilization is the policy of altering the domestic
DC credit extended by the central bank in an
M0=R

Central Bank credit Reserves and central equal and opposite direction to the variation
to private sector bank balances of of foreign exchange reserves so that the
domestic banks monetary base remains unchanged.
Foreign Exchange (FECB)
Assets

Liquidity Liquidity
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Errol D’Souza

Simplified Central Bank Balance Sheet

Assets Liabilities

Central Bank credit Currency in circulation

to government
DC
M0=R

Central Bank credit Reserves and central

to private sector bank balances of
domestic banks
Foreign Exchange (FECB)
Assets

Sterilization involves DC = − FE CB so that M 0 = 0

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