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Chapter - 18, Balance of Payment And Exchange Rate, _______________________________________________, Short Answers & Long Answers, 1. Discuss briefly various components of Balance of, Payment (BOP). [6 Marks], OR, Explain the components of Current Account and, Capital Account of Balance of Payment. [6 Marks], Answer - The components of the balance of payment are, as follows:, 1. Current account: The current account of BOP records, the transactions related to exports and imports of goods, and services and unilateral transfers from and to the rest of, the world. The current account of BOP records the following, components:, (i) Export and import of goods : It refers to the import and, export of all tangible goods into or out of the country as the, case may be. The import of goods is shown on debit side of, the account whereas export of goods is shown on credit, side of the account., (ii) Export and Import of services: It refers to the import and, export of all intangible services into or out of the country as
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the case may be. The services included here are non factor, services only., (iii) Unilateral Transfers: It refers to the receipts and, payments of foreign currency which take place without, exchange of goods or services.These are one-sided, payments and include gifts, Charit, donations, etc., (iv) International reserves : It refers to the factor payments, like compensation to employees and investments., Compensation to employees includes wages, salary,, bonus, etc. Investment income includes receipts and, payment of dividends, interest,profit,etc., 2. Capital account: The capital account of BOP records all, transactions of a country that alter the status of assets and, liabilities of a country. The capital account of BOP records, the following components:, (i) Loans to and borrowings from abroad: This component, consists of all loans and borrowings given to or received, from the rest of the world. It includes both private sector, loans and public sector loans., (ii) Investments to and from abroad: This component, includes investments made by non-residents in shares and, equities in a country or investment in real estate in any, country. The former investment does not provide any, control over the asset and is known as portfolio investment., The latter investment provides control over the asset and it, is known as foreign direct investment.
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(iii) Autonomous and accommodating items: Autonomous, and accommodating items are used to ensure that BOP, balances are maintained. These are used to account for, errors and discrepancies in BOP account., (iv) Rupee Debt Services : When loans are procured in the, form of domestic currency like Rupee in India and the debt, is paid by export of goods to that country,such services are, classified as Rupee Debt Services., , 2. Discuss the causes of Disequilibrium of Balance of, payment. [4/6 Marks], Answer: Causes of Disequilibrium in the Balance of, Payment (BOP), (i) Fall in foreign demand: BOP deficit may arise due to a, shift in foreign demand away from domestic goods to, foreign products because of changes in preference or lower, prices of foreign products. This leads to decreases in, exports making the BOP unfavourable., (ii) Inflationary pressure in the economy: A high rate of, inflation at home encourages imports by making it relatively, cheaper leading to decrease in the country’s, competitiveness in the world market and reduces exports., (iii) Developmental expenditure: Developing countries are, poor. Hence they have to depend upon the developed, nations for the supply of machines, technology etc.
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However, they cannot step up their exports to finance the, increased imports, leading to a deficit., (iv) Increase in the cost structure of export industries: It, reduces the volume of exports by reducing the, competitiveness of these industries in the world market (it, may arise due to higher wages, higher prices of raw, materials or inflation). Fall in exports makes the BOP, unfavourable., (v) The decrease in supply: A fall in supply at home say, agricultural production due to crop failure say, or labour, strike, shortage of raw materials etc. leads to fall in exports, and imports may increase to overcome the scarcity, resulting an adverse BOP., (vi) Appreciation in the exchange rate: Appreciation, increases the external value of a currency, making imports, cheaper and exports dearer, leading to an adverse BOP., (vii) Increase debt burden: Developing countries import, capital largely in the form of portfolio investment, creating a, large debt burden. Hence these countries are required to, make large payments to the developed countries., (viii) Demonstration effect: People of underdeveloped, countries try to imitate the consumption pattern of, developed countries regarding luxuries, leading to an, increase in imports and hence a deficit.
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(ix) Population pressure: A rapid increase in population in, underdeveloped countries increase the demand for, consumer goods. Hence exports surplus has fallen resulting, in an adverse effect on the BOP., (x) Political factors: They are also responsible for making, BOP unfavourable. Political turmoil and instability in a, number of countries-gulf countries, African countries,, Afghanistan etc. have an adverse effect on their BOP., 3. Explain the measures taken to correct, Disequilibrium in the Balance of Payment., [6/4 Marks], Answer: A number of steps can be taken to solve the, problem of deficits in the balance of payments. The main, methods of correcting the adverse balance of payments, are:, (i) Depreciation: Under the flexible exchange rate system,, changes in the rate of exchange will automatically adjust, the balance of payments. Depreciation of the country’s, currency will wipe out deficits in the balance of payments., Depreciation of currency means rise in the price of foreign, currency or, which is the same thing, fall in the price of, domestic currency., (ii) Devaluation: A country can devalue its currency to wipe, out deficit in the balance of payments. This makes imports, expensive to domestic consumers and its exports cheaper, in foreign countries. If demand and supply elasticities are
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fairly high, this will definitely lead to a fall in imports and a, rise in exports and thereby an elimination or reduction of, balance of payments deficit., (iii) Import Control: Reports may be kept in check through, the adoption of a wide variety of import control measures, such as quotas and tariffs. Quotas limit the volume of, imports by applying quantitative restrictions. The, government may for example, decide that only 90 per cent, of last year’s volume of imports can be imported this year., The government may also increase the import duties or, tariffs. This will raise the prices of imported goods and, reduce imports. As a consequence, balance of payments, deficit is reduced., (iv) Export Promotions: The Government of the country, having adverse BOP stimulate exports by reducing export, duties, giving subsidies and cash assistance to exporters,, providing technical and marketing assistance to exportoriented units, providing facilities like quality control,, arranging exhibitions of exportable goods, exempting export, goods from taxes, etc. Attempts should be made to attract, foreign tourist to encourage tourism. All these measures will, increase the volume of exports thereby reducing the deficit, in the BOP., (v) Production of Import Substitutes: Steps may be taken to, encourage the production of import substitutes. This will, save foreign exchange in the short- run by replacing the, use of imports by their import substitutes. If the industries, producing import substitutes develop ultimately because of
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various incentives provided to these industries, they may, turn out to be export earners as well., 4. Balance of payment always balances in the, accounting sense. Explain briefly. [3 Marks], Answer: The total receipts in the BOP account are equal to, the aggregate payments. Hence, there is neither any, surplus nor any deficit in the BOP account. In fact, in the, book keeping or accounting sense every 'credit' entry must, have a corresponding ‘debit’ entry. The golden rule of, double-entry bookkeeping is "Debit what comes in and, Credit what goes out". The aggregate ‘credit balance’ of all, credit accounts must be equal to the aggregate ‘debit, balance’. So in the accounting sense, the BOP account is, always balanced., , 5. Show with the help of diagram of how, exchange rate is determined under flexible, exchange rate system. [6 Marks], Answer: The flexible exchange rate is determined, by the interaction of the forces of demand and, supply. The equilibrium exchange rate is, determined at a level where demand for foreign, exchange is equal to the supply of foreign, exchange. This will be clear from the given, Diagram.
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As seen in the diagram, demand and supply of, foreign exchange are measured on the X-axis, whereas the rate of foreign exchange on the Yaxis. DD is the downward sloping demand curve of, foreign exchange and SS is the upward-sloping, supply curve of foreign exchange. Both the curves, intersect each other at point ‘E’. The equilibrium, exchange rate is determined at OR and the, equilibrium quantity is determined at OQ.
