IE Unit 4- Balance of payments

What is the Balance of Payments (BoP)

The Balance of Payments (BoP) is a systematic record of all economic transactions between residents of a country and the rest of the world during a year. It includes transactions in goods, services, income flows, financial assets, and reserve movements.

Accounts of BOP

current and capital in tuition book

What is the foreign exchange market, and how are exchange rates determined?

The Foreign Exchange Market (FOREX) is a global marketplace where currencies are bought and sold. According to the PDF, it is the world’s largest and most liquid financial market, operating through spot markets, forward markets, swaps, futures, and options.Key features:

• Spot Rate: Price for immediate currency delivery.

• Forward Rate: Price fixed today for delivery at a future date.

• Foreign Exchange Swaps: Simultaneous spot purchase and forward sale (or vice-versa).

• Futures & Options: Standardised contracts traded in organised exchanges.

Exchange Rate Determination (from PDF)

The PDF explains that exchange rates are influenced by:

• 1. Demand & Supply of Currencies

  If demand for USD rises relative to INR, USD appreciates and INR depreciates.

  2. Interest Rate Differentials

  Higher interest rates attract capital flows into a country → currency appreciates.

  3. Expectations

  If markets expect future appreciation, investors buy that currency now.

  4. Capital Flows

  The PDF notes that capital flows dominate trade flows today.

  International economics notes

  5. Monetary Factors

  Money supply growth → inflation → long-run depreciation.

Modern theories emphasise that financial flows dominate trade flows, making exchange rates more sensitive to capital movements.

The monetary approach and the portfolio balance approach explain how money supply, wealth, asset preferences, and expectations influence exchange rates.

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How are long-run price levels connected to exchange rates?

According to the PDF, in the long run, exchange rates are primarily determined by relative price levels between countries. This relationship is formalised in the Purchasing Power Parity (PPP) theory.Long-run mechanism:

• If a country’s price level rises faster, its currency depreciates.

• If its price level grows more slowly, the currency appreciates.

The monetary approach (Section 15.3) shows that:

• Exchange rates adjust proportionally to relative money supplies, because higher money supply → higher domestic prices → currency depreciation.

• Over time, exchange rates move to preserve the real purchasing power of currencies.

Thus, in the long run:

R=P/P∗

If domestic inflation > foreign inflation, the domestic currency falls.

What is Purchasing Power Parity (PPP) and how does it relate to exchange rates?

PPP is the most important long-run theory of exchange rates, extensively discussed in the PDF. It has two versions:

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A. Absolute PPP

States that the exchange rate should equal the ratio of price levels between two countries:

R=P/P∗

This is based on the law of one price, which says that identical goods should sell for the same price globally when expressed in a common currency.

However, the PDF emphasises why absolute PPP often fails:

• Non-traded goods (haircuts, local services)

• Transport costs

• Trade barriers

• Capital flows

• Market imperfections

Thus, absolute PPP is not used for practical exchange rate determination.

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B. Relative PPP

A more realistic version stating:

R1/R0=P1/P0 / P1∗/P0∗

Meaning:
Exchange rates change in proportion to inflation differentials.
If domestic inflation exceeds foreign inflation by 10%, the currency should depreciate by approximately 10%.

International economics notes

The PDF provides:

• Diagram evidence of inflation vs. depreciation (Figure 15.2).

• Case studies like the Big Mac Index to show deviations.

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C. Empirical Evidence (from PDF)

Studies show:

• PPP holds better in the long run than in the short run.

• Deviations adjust slowly—half-life of PPP deviation is 4–5 years.

• Capital flows, speculation, and shocks cause short-run deviations.

Types of Exchange Rate Regimes

• Fixed

• Floating

• Managed float

Each affects currency stability and capital flows differently.

FROM BOOK