Balance of Payments and Exchange Rate
The exam tests the structure of the balance of payments, the classification of transactions, and how fixed and flexible exchange rates are determined and adjusted.
Core rules
- The BoP records all economic transactions with the rest of the world and always balances, because accommodating transactions fill the gap left by autonomous ones.
- Current account: visible goods, services, factor income and unilateral transfers. Capital account: FDI, FPI, loans, banking capital and changes in reserves.
- A current account deficit means receipts from trade and transfers fall short of payments; it must be financed by capital inflows or by drawing down reserves.
- Fixed rate: the central bank pegs the currency and intervenes; official changes are devaluation and revaluation. Flexible rate: demand and supply set the price; market changes are depreciation and appreciation.
- Demand for foreign currency comes from imports and outflows; supply comes from exports and inflows; the equilibrium rate equates the two.
- The rupee is partially convertible on current account and has been under a managed float since 1993.
Worked example
Rising Indian imports raise the demand for dollars, shifting the demand curve right and moving the rate from ₹80 to ₹83 per dollar. An exporter receiving $1,000 now gets ₹83,000 instead of ₹80,000, so exports become more competitive and imports dearer. This improves the trade balance over time, though the rupee import bill rises immediately.
Traps
Calling devaluation a market outcome - it is a policy decision under a fixed rate. Claiming the BoP can be in permanent surplus because it balances. Placing unilateral transfers in the capital account. Confusing rupee depreciation with domestic inflation. Treating every current account deficit as a crisis.