Foreign Exchange Determination and Balance Of Payment
Q1. Define foreign exchange.
Ans1.Foreign Exchange refers to all currencies other than the domestic currency of a given
country. It is primarily used for making international payments.
Q2. Define foreign exchange rate & foreign exchange market.
Ans2.The rate at which the currency of one country can be exchanged for currency of another
country is termed as ‘foreign exchange rate’. It is simply the price of one currency in
terms of another and express the external value of domestic currency.
Foreign Exchange Market is a market in which the currencies of various countries are
converted, exchanged and graded with one another.
It is not physical place but a network of communication systems which connects all the
institutions that influence the exchange rate. For e.g., specified foreign exchange deal-
ers, brokers, banks, govt. agencies, etc.
Q3 What are the functions performed by foreign exchange market
Ans Foreign Exchange market performs, mainly 3 functions
a) Transfer function - To transfer purchasing power between countries
b) Credit function - To provide credit channels for foreign Trade
c) Hedging function - To protect against foreign exchange risk arising out of
uncertainty of Forex Rate in future.
Q4. Distinguish between Fixed exchange Rate, Flexible exchange rate and Man-
aged Floating.
Ans. Fixed exchange rate The system of exchange rate in which exchange rate is officially
declared to be fixed by the govt. All the foreign central banks stand ready to buy and sell
their currencies at the fixed price. The value of each currency is determined in terms of
gold. Therefore, it is also called gold standard system.
Only a very small deviation from this fixed value is allowed . Changes in demand and
supply of foreign exchange are not allowed to effect the foreign exchange rate.
Flexible exchange rate - The system of exchange rate in which the value of currency is
allowed to adjust freely and is determined by DD for and SS of foreign exchange is
called flexible exchange rate system.
Managed Floating - Under this system market is allowed to determine the exchange
rate and the central banks buy and sell foreign currencies to ensure that short term
volatality in exchange rates did not occur. Authorities take decisions to interwene when-
ever they feel appropriate.
- Govt. sells foreign exchange when it finds exchange rate increasing in the
market, in order to to increase its supply. This helps to check the increase in the Forex
rate.
- Govt. buys Forex when exchange rate is falling in the market. In order to in-
crease its demand. This helps to check the fall in the Forex rate.
Q5. How is exchange rate determined under flexible exchange rate system?
Ans Exchange rate of a country is determined by demand and supply of foreign exchange in
the foreign exchange market, since all the countries follow flexible exchange rate sys-
tem.
Demand curve for foreign exchange is downward sloping i.e demand increases when
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exchange rate falls.
Supply curve for foreign exchange is upward sloping i.e. supply increases when ex-
change rate is increased.
Graphically, the intersection of dd & ss curves determines the equilibrium exchange
rate and equilibrium quantity of foreign currency sold in the market.
Exchange rate is determined where Demand for foreign exchange equals the Supply of
foreign exchange. Diagramatically,
‘e; is the equilibrium implyingr Re is the exchange rate & OQe units of foreign
Exchange are exchanged.
Exchange rate can’t be fixed at any other point.
At R2 SS > DD Excess Supply, foreign exchange rate will be .
At R1 DD > SS Excess Demand, foreign exchange rate will be .
Changes in demand and supply, cause exchange rate to increase or decrease hence it
is called flexible exchange rate system.
-If DD for Foreign exchange increases or SS of foreign exchange falls (ie. DD/SS
curves shift), the exchange rate will rise and the domestic currency would depreciate.
-If SS of Foreign exchange increases or DD of Foreign Exchange falls (ie. DD/SS
curve shift), leading to fall in the exchange rate and our currency would appreciate.
Q6. Define appreciation & depreciation of currency.
Ans. Appreciation - It is the in the value of domestic currency in terms of foreign currency,,
i.e. lesser of domestic currency is to be given in exchange of foreign currency. E.g.
1 $ = 30 Rs.changes is to 1 $ = 25 Rs.
Depreciation - It is the in the value of domestic currency in terms of foreign currency,,
i.e. more of domestic currency has to be exchanged to get foreign currency.(make ex-
ports cheaper, imports expensive)
E.g. 1 $ = 30 Rs. changes is to 1 $ = 35 Rs
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Q7. What are the sources of demand of foreign exchange?
Ans. Country requires foreign exchange
(a) To pay for imports of visible and invisible items i.e. to purchase goods and ser
vices from foreign countries.
(b) To purchase financial assets in a particular country, that is investment by residents
abroad, e.g., Purchase of Share, bonds, FDI, etc.
(c) To send gifts, remittances, foreign grants abroad i.e., unilateral transfers.
(d) To speculate on the value of foreign currency.
There is an inverse relationship between price of foreign exchange and demand
for it and that is why demand curve is downward sloping. As the foreign exchange rate
decreases demand for foreign exchange increases.
Q8 Why is demand curve of foreign exchange downward sloping?
OR
Why does demand for foreign Exchange increases if there is appreciation of
domestic currency (depreciation of the foreign currency)
Ans Demand curve of foreign exchange slopes down i.e. less of foreign exchange is
demanded as exchange rate increases and more is demanded when exchange rate
falls
Exchange rate
D
R1
R2
Dex
Q1 Q2 Units of Exchange
This is due to the fact that when foreign exchange rate falls i.e there is appreciation of
domestic currency. Foreign exchange becomes cheaper. Less of domestic currency
has to be paid for purchasing foreign currency.
– There is fall in rupee cost of foreign goods therefore imports become cheaper, their
demand increases as a result demand for foreign exchange, which is required to
pay for them, increases.
– Foreign assets become cheaper for the domestic country therefore
investments abroad by residents increase resulting in increase in demand of
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foreign exchange.
Therefore when foreign exchange rate falls, there is increase in demand for
import and investment. As a result more foreign exchange is demanded to pay
for them.
Q9. What are the sources of supply of Foreign Exchange?
Ans Supply of foreign exchange comes from following sources:
1. From export of visibles & invisibles i.e from sale of goods and services to rest of
the world.
2. From sale of financial assets to ROW when foreigners invest in our country,
3. Remittances, Foreign aid, grants from abroad, that is, unilateral transfer receipts.
4. For speculation in the value of foreign exchange.
There is a direct relationship between price of foreign exchange and its SS i.e. SS
curve is upward sloping.As the foreign exchange rate increases supply for foreign ex-
change increases.
Q10. Why is supply curve of foreign exchange upward sloping?
OR
Why supply of foreign exchange increases if there is depreciation of domestic
currency (appreciation of foreign currency.)
Ans Supply curve of foreign exchange slopes upward i.e supply of foreign exchange increases
when the exchange rate is increased.
Exchange Rate
S
R2
R!
S
Q1 Q2 Units of Exchange
This is due to the fact that increase in foreign exchange rate means fall in the value of
domestic currency and foreign currency becoming stronger. As a result
– Price of country’s goods falls in the International market ie. exports becomes cheaper.
This increases demand for export which in turn increases the supply of foreign
exchange.
– Domestic assets also become cheaper for a foreigners. There is increase in
foreign investment into the country which increases the supply of foreign ex-
changes.
Therefore an increase in foreign exchange rate results in more inflow of foreign cur-
rency into the country, increasing its supply.
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Q11. Differentiate between spot and forward market.
Ans. Spot Market- refers to the market in which foreign currency is available on the spot. It
primarily deals with current transactions and tells how many units of other currency can
be purchased against our currency at a point of time.
Forward Market -It is the market in which the forward contract for purchase and sale
of foreign exchange are made at forward rate. It covers all the transactions which will
occur in the future. It reduces risk of loses due to adverse changes in exchange rate.
Q12. Distinguish between depreciation and devaluation of domestic currency.
Ans. Depreciation - It is the in the value of domestic currency in terms of foreign currency,,
due to market forces of demand and supply i.e. more of domestic currency has to be
exchanged to get foreign currency.(make exports cheaper, imports expensive)
E.g. 1 $ = 30 Rs. changes is to 1 $ = 35 Rs
Devaluation - When government lowers the value of domestic currency in terms
of foreign currency to rectify BOP deficit.(i.e tries to increase exports and decrease
imports).
Whenever country’s B.O.P. is in deficit i.e. foreign exchange receipts are less than for-
eign exchange payments.
In such a situation when devaluation of Currency take place.
- Exports became cheaper, Exports will increase, causing receipts of For-
eign exchange to increase.
- Imports became expensive, Imports will decrease, causing payment or out-
flow of foreign exchange to decrease.
This helps to reduce / check the deficit of B.O.P.
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BALANCE OF PAYMENTS
Q1. Define Balance of Payment account and briefly describe its structure.
Ans1.Balance of Payment account is a statement of all the international economic transactions be-
tween residents of a country and rest of the world, that results in outflow and inflow of
Foreign Exchange, during a period of one accounting year.
Features of Balance of Payment
1. All transactions are recorded in double-entry book keeping system.
2. On the credit side all the items that result in inflow of foreign exchange are recorded.
3. On the Debit side, all the items for which Country makes Payment are recorded.
4. In book keeping sense, Balance of Payment always balances.
Balance of Payment A/ct
Credit (Receipt / Inflow) Debit (Payment / Outflow)
CURRENT A/c
a) Export of Visibles(Goods) a) Import of Visibles
b) Export of Invisibles(Services) b) Import of Invisibles
c) Unilateral Transfer receipt - gifts, c) Unilateral Transfers payment.
remittances, foreign-aid, grants.
II CAPITALA/c
a) Borrowings from abroad. a) Lending to ROW
b) Repayment of loans by ROW. b) Repayments of loan to ROW
c) Sale of assets to foreigners c) Purchases of assets abroad
d) Foreign Direct invt. from row d) Foreign Direct Investment by resident abroad
III OTHER TRANSACTIONS
a) Error and Ommissions
b) Official Reserves Transactions
Q2. Explain the components of current account of BOP.
Ans It records all the international transactions that do not effect assets or liabilities of residents of
a country’s with respect to rest of the world.
Main components of current account are
1. Export / Import of visibles – This refers to sale and purchase of goods or merchandise.
2. Export Import of invisibles – This refers to sale purchase of services to rest of the world
like banking services, insurance services, labour services, capital etc.
3. Unilateral transfers– Foreign aid, grants, remmitances,
Q3. What is Balance of Trade.
Ans Difference between value of exports of visibles and imports of visibles is called Balance of
trade
Q4. What is balance of invisibles.
Ans. Difference between value of exports of invisibles and import of invisibles is called Balance of
invisibles.
Q5. When is Balance of Trade negative / unfavourable.
Ans. When the value of Exports of visibles in less than value of imports of visible.
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Q6. What is Balance of current account.
Ans. Difference between total current receipts of foreign exchange (from exports and unilateral
transfers) and total current payments of foreign exchange (for imports and unilateral transfers)
is called Balance of current account.
Q7. What do you mean by current account deficit.
Ans. When the current receipts of foreign exchange are less than current payments of foreign exchange,
there is current account deficit.
Q8. What is of trade account?
Ans. It is an account that records exports and imports of goods ( visibles).
Q9. Explain the components of Capital Account.
Ans. It records all those international transactions that effect assets and liabilities of domestic
country with respect to rest of the world.
Main components of capital account are
1. Lending to and borrowing from ROW
2. Repayment of Loans to and by ROW
3. Sale of purchase of assets from ROW (Portfolio investment)
4. Foreign Direct Investment
Q10. What is the difference between Foreign Direct Investment and Portfolio Investment?
Ans
– Foreign Direct Investment - These are transactions that involve purchasing the assets in the
other country and also acquiring control over it.
It includes acquisition of firm in the other country or purchases of a house in the other country.
– Portfolio Investment - This involves purchases of assets without aquiring control over them.
eg. Purchase of shares and bonds of a company in the other country or giving loans to foreign
firms or government.
All the purchase of assets from the other countries appear as negative items because money
flows out and all the capital inflows are taken as positive items.
Q11. Explain the Other Activities / accommodating items of BOP.
These are the items which are included so that BOP balance.
a) Errors and Omissions - These entries are done to wipe off all the discrepancies which may
occur due to lack of data or lack of right data.
b) Official reserve transactions - These transactions are undertaken with the aim of
maintaining the identity of BOP i.e. to balance credit and debit side.They are carried by the
central bank keeping in mind their effect on BOP and exchange rate. As such they are called accom-
modating transactions. These transactions are
(i) Change in domestic country’s official reserve assets which are held in the form of (i)
foreign currency (ii) foreign currency security (iii) Gold and (iv) SDR with IMF.
Reduction in these assets appear as credit items (there sale causes inflow of foreign exchange into
country) & vice-versa.
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Note - If B.O.P. is the deficit (automonus Receipts < automonus Payments), there will be decrease
in Foreign Exchange Reserve to increase inflow of Foreign Currency i.e. accomodating
Receipts. In this way Foreign exchnage receipts become equal to foreign exhange payments.
- If B.O.P. is in surplus (automonus Payments < automonus Receipts) These will be in
Foreign Exchange receives i.e. accomodating payments. In this way B.O.P. will Balance i.e.
Receipts = Payments.
Q12. When is Balance of Payment in deficit / unfavourable / negative.
Ans. The Balance of payment is in deficit if the autonomous receipts of Foreign Exchange are less
than autonomous payments of foreign exchange i.e total current and capital receipts of foreign ex
change are less than total current and capital payments of foreign exchange.
Q13. When is Balance of Payment in surplus/favourable/positive ?
Ans. The Balance of payment is in deficit if the autonomous payment of Foreign Exchange are less
than autonomous receipt of foreign exchange i.e total current and capital payment of foreign ex
change are less than total current and capital receipt of foreign exchange.
Q14. How is deficit in the balance of payment financed?
Ans. Every country maintains foreign exchanges reserves in the form of currency, Foreign security, gold,
SDR with IMF.
Reduction in these reserves are used for financing expenditure abroad. It is taken as a credit item
as it causes inflow of Foreign Exchange.
eg. it can borrow from IMF, sell Foreign securities
This is shown as decrease in Foreign reserves and causes inflow of Foreign currency. This will
balance the BOP in accounts terminology. (accomodating receipts in the BOP make up for shortfall
of atonomous receipts)
Q15. Differentiate between Balance of Trade and Balance of Payment.
Ans. Balance of Trade Balance of Current A/c
(i) Difference between value of exports of (i) The difference between total
visibles and imports of visibles is called current receipts of foreign exchange
Balance of trade (from export of visibles, invisibles and uni-
(ii) It records only merchandise (i.e. goods) lateral transfers) and total current Pay-
transactions. ment of Foreign Exchange (for imports
of visibles, invisibles and unilateral trans-
fers ) both current & capital is called Bal-
ance of current A/c.
(ii) It includes balance of trade, balance of
services, balance of unrequited transfers
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Q16. Give two examples of invisible items of balance of payments.
Ans. The two examples of invisible items of balance of payments are:-
1) Export/import of Non factor services -
a) Services like shipping, insurance banking
b) Tourism.
2) Export / import of Factor services - Labour services, Capital etc. eg. dividends, interest
from R.O.W.
Q17. Name the two accounts of balance of payment.
Ans. 1) Current account
2) Capital account
Q18. What type of activities are recorded in the current account of balance of payment?
Ans. The current account records imports and exports of goods and services and unilateral transfers.
Q19. What type of transactions are recorded in the capital account of balance of payments?
Ans. The capital account records all international transactions that involve a resident of the domestic
country changing his assets with a foreign resident or his liabilities to a foreign resident.
Q20. What are unilateral transfers or unrequited transfers?
Ans. Unilateral transfer are receipts which residents of a country make without getting anything in return
eg. Gifts etc. The net balance of visible trade, invisible trade and of unilateral transfers is the
balance on current account.
Q21 Are exports and imports recorded as positive or negative items in foreign exchange?
Ans. Exports cause an inflow of foreign exchange into the country so they are entered as positive items.
Imports cause an outflow, so they are entered as a negative item.
Q22 Give an example of private unrequited transfers.
Ans. Gifts that domestic residents receive from or make to foreign residents eg. An Indian resident
working in Dubai sending back money to their relative in India.
Q23 Give an example of official unrequited transfers.
Ans. Receipt of or giving of foreign aid from developed countries to developing countries,
Q24 What is meant by ‘ Portfolio Investment’ in the capita! account transactions?
Ans. Portfolio Investment is the acquisition of an asset that does not give the purchaser control over the
asset. For eg. Investment in the purchase of shares in a foreign company or of bonds issued by a
foreign govt.
Q25 What is meant by ‘Direct Investment’ in the capital account transactions?
Ans. Direct investment is the act of purchasing an asset and at the same time acquiring control of it. For
example, acquisition of a firm in one country by a firm in another country.
Q26 Differentiate between autonomous and accommodating items.
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Ans. Autonomous Items Accommodating Items
1. Autonomous-items refer to 1. This refers to transactions that
international are undertaken by the Central Bank/
transactions that take place government to maintain the
due to some economic B.O.P. identity i.e. to equate
motive such as profit. the credit and debit side.
2. These transactions are 2. These are undertaken keeping in
independent of the state of the mind their impact on B.O.P.
country’s BOP.
3. These items are often called 3. These items are called below the
above the line items in the line items
BOP.
4. Eg. exports of visibles and 4. Eg. official reserve transactions
invisibles
Q27. If current A/C is in deficit does it imply unfavourable balance of payment.
Q28. If there are Accommodating receipts in the balance of payment account it means favourable
balance of payment. Is it true or false.
Q29. Where the following transaction recorded in B.O..P.
- External assistance
- Interest Paid on loan taken from World Bank.
- Import of Machine
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