Foreign Exchange Rate & Balance of Payments – Quick Review

Foreign Exchange Rate (FER)

• FER = price of one currency in terms of another; e.g. $\$1 = ₹81 \Rightarrow ₹1 = \$0.0123$.
• Many bilateral rates exist; fluctuate with market forces unless fixed by authority.
• Exchange rate set where $\text{Demand} = \text{Supply}$ of foreign currency under flexible system.

Currency Depreciation vs. Appreciation

• Depreciation: fall in domestic currency’s value; e.g. $\$1:₹81 \rightarrow \$1:₹82$.
  • Exports ↑, Imports ↓, Net Exports ↑, National Income ↑.
• Appreciation: rise in domestic currency’s value; e.g. $\$1:₹82 \rightarrow \$1:₹81$.
  • Imports ↑, Exports ↓, Net Exports ↓, National Income ↓.

Exchange-Rate Systems

• Fixed (Pegged): rate set by govt.; needs large reserves; stable but inflexible; devaluation/revaluation possible.
• Flexible (Floating): rate set by demand & supply; self-correcting; volatile; may cause speculation & inflation.
• Managed Float (Dirty Float): market-based but central bank intervenes to keep rate within band; hybrid of above.

Devaluation vs. Depreciation

• Devaluation: govt.-induced cut in fixed rate (fixed system).
• Depreciation: market-driven fall (flexible system).
• Revaluation / Appreciation are corresponding upward moves.

Demand for Foreign Exchange

• Uses: import goods & services, tourism, gifts/remittances out, buy foreign assets, speculation, repay foreign loans.
• Demand rises when foreign currency becomes cheaper.
• Demand curve: downward-sloping (price–quantity inverse).

Supply of Foreign Exchange

• Sources: exports, foreign investment in home country, remittances in, speculation, foreign loans, grants.
• Supply rises when foreign currency becomes dearer.
• Supply curve: upward-sloping (price–quantity direct).

Equilibrium & Shifts

• Equilibrium rate $R_e$ at intersection of D & S.
• Excess demand → currency depreciation; excess supply → appreciation.
• Rightward D shift or leftward S shift → $R_e$ rises (domestic depreciation).
• Leftward D shift or rightward S shift → $R_e$ falls (domestic appreciation).

Foreign Exchange Market

• Network where currencies are bought/sold by individuals, firms, banks & central bank.
• Functions:
  • Transfer purchasing power.
  • Provide credit for trade (bills of exchange).
  • Hedging: lock-in future rate to avoid risk.
• Markets: Spot (settlement ≤2 days, spot rate) & Forward (future settlement, forward rate).

Balance of Payments (BOP)

• Double-entry record of all economic transactions between residents & rest of world during a period.
• Credit (+) = inflow of foreign exchange; Debit (–) = outflow.
• Accounting identity: \text{Current A/c} + \text{Capital A/c} + \text{Errors & Omissions} = 0.

Balance of Trade (BOT)

• BOT = Exports of goods – Imports of goods.
  • Surplus BOT >0; Deficit BOT <0; component of current account.

Current Account

• Goods (visible trade) → BOT.
• Services (invisibles): Factor (wages, interest, rent, profits) & Non-factor (shipping, banking, insurance, travel…).
• Unilateral transfers (gifts, remittances).
• Surplus (CAS) when credits > debits; Deficit (CAD) when debits > credits.

Capital Account

• Borrowings & lendings (loans).
• Investments:
  • FDI (control).
  • Portfolio / FII (no control).
• Change in foreign-exchange reserves (↓ reserves = credit; ↑ reserves = debit).
• Surplus signals net capital inflow; Deficit signals net outflow.

Autonomous vs. Accommodating Items

• Autonomous (\"above the line\"): motivated by profit/need; cause BOP imbalance.
• Accommodating (\"below the line\"): undertaken to finance imbalance (use reserves, borrow from IMF, etc.).

Deficit / Surplus Handling

• Deficit: financed by drawing down reserves or new foreign borrowing.
• Surplus: may be used to build reserves or buy foreign assets.

Key Equations & Identities

• $\text{BOT} = X<em>g - M</em>g$.
• $\text{Current Account Balance} = (X<em>g - M</em>g) + (X<em>s - M</em>s) + \text{Net Transfers}$.
• $\text{Overall BOP} = 0\;\text{(accounting sense)}$; disequilibrium refers to autonomous items only.