Balance of Payments and Exchange Rate
Balance of Payments and Exchange Rate tests the structure of BoP accounts and the working of fixed, flexible and managed floating exchange rates.
Core rules
- The BoP records all economic transactions between residents and the rest of the world in a year.
- Current account: visible trade in goods, plus invisibles (services, income, transfers).
- Capital account: FDI, portfolio investment, external loans, banking capital, changes in reserves.
- Errors and omissions is the residual item; the accounts must balance in an accounting sense.
- Autonomous transactions are motive-driven; accommodating transactions finance the gap.
- Fixed rate: the central bank intervenes to hold the rate. Flexible rate: demand and supply determine it. Managed floating: market-determined with intervention.
- Devaluation or depreciation makes exports cheaper and imports dearer; appreciation does the opposite.
Worked example
Suppose the rupee-dollar rate moves from ₹75 to ₹80 per dollar. The dollar has appreciated against the rupee, and the rupee depreciated by (80 − 75)/75 × 100 = 6.67%. An Indian exporter receiving $100 now gets ₹8,000 instead of ₹7,500, so exports become more competitive, while an importer paying $100 must spend ₹500 more.
Traps that cost marks
- Claiming a BoP surplus is impossible because the accounts balance; the current account can still be in deficit or surplus while the overall BoP balances.
- Using devaluation and depreciation interchangeably; devaluation is a deliberate policy under a fixed rate.
- Forgetting that remittances belong to the current account, not the capital account.