UNIT II

Content

2.1 Balance of Trade

2.2 Balance of Payment
2.3 Causes of BOP Disequilibrium
2.4 Methods to correct BOP disequilibrium
2.5 Exchange Rate Concept
2.6 Fixed and Floating Exchange Rate
2.7 Euro- Dollar Market

2.1 BALANCE OF TRADE

Balance of trade (BOT) is the difference between the value of a country's exports and the value
of a country's imports for a given period. Balance of trade is the largest component of a
country's balance of payments (BOP). Sometimes the balance of trade between a country's
goods and the balance of trade between its services are distinguished as two separate figures.
The balance of trade is also referred to as the trade balance, the international trade balance,
commercial balance, or the net exports. The formula for calculating the BOT can be simplified
as

Balance of Trade = Total value of exports - Total value of imports

Economists use the BOT to measure the relative strength of a country's economy. A country
that imports more goods and services than it exports in terms of value has a trade deficit or a
negative trade balance. Conversely, a country that exports more goods and services than it
imports has a trade surplus or a positive trade balance. A country with a large trade deficit
borrows money to pay for its goods and services, while a country with a large trade surplus
lends money to deficit countries. In some cases, the trade balance may correlate to a country's
political and economic stability because it reflects the amount of foreign investment in that
country. BOT measures the flow of exports and imports over a period of time.

When Exports = Imports Equilibrium Balanced Trade

When Exports > Imports Positive BOP Surplus Trade

When Exports < Imports Negative BOP Deficit Trade

2.2 BALANCE OF PAYMENT
According to Kindle Berger, "The balance of payments of a country is a systematic record of
all economic transactions between the residents of the reporting country and residents of
foreign countries during a given period of time". It is a double entry system of record of all
economic transactions between the residents of the country and the rest of the world carried
out in a specific period of time when we say “a country’s balance of payments” we are referring
to the transactions of its citizens and government.

The balance of payments of a country is a systematic record of all economic transactions

between the residents of a country and the rest of the world. It presents a classified record of
all receipts on account of goods exported, services rendered and capital received by residents
and payments made by them on account of goods imported and services received from the
capital transferred to non-residents or foreigners.

Features of BOP:

 It is a systematic record of all economic transactions between one country and the rest
of the world.
 It includes all transactions, visible as well as invisible.
 It relates to a period of time. Generally, it is an annual statement.
 It adopts a double-entry book-keeping system. It has two sides: credit side and debit
side. Receipts are recorded on the credit side and payments on the debit side.

Balance of Trade V/s Balance of Payment

The Balance of Payment takes into account all the transaction with the rest of the worlds

The Balance of Trade takes into account all the trade transaction with the rest of the worlds

BOP BOT
It is a broad term. It is a narrow term.
It includes all transactions related to visible, It includes only visible items.
invisible and capital transfers.
It is always balances itself. It can be favourable or unfavourable
BOP = Current Account + Capital Account + BOT = Net Earning on Export - Net payment
or - Balancing item (Errors and omissions) for imports.
 Following are main factors which affect BOP Following are main factors which affect
a) Conditions of foreign lenders. BOT
b) Economic policy of Govt. a) cost of production
c) all the factors of BOT b) availability of raw materials
c) Exchange rate
d) Prices of goods manufactured at
home

Importance of Balance Of Payments

1. BOP records all the transactions that create demand for and supply of a currency.
2. Judge economic and financial status of a country in the short-term
3. BOP may confirm trend in economy’s international trade and exchange rate of the
currency. This may also indicate change or reversal in the trend.
4. This may indicate policy shift of the monetary authority (RBI) of the country.
5. BOP may confirm trend in economy’s international trade and exchange rate of the
currency. This may also indicate change or reversal in the trend.

The various components of a BOP statement

1. Current Account
2. Capital Account
3. Reserve Account
4. Errors & Omissions
1. Current Account Balance

BOP on current account is a statement of actual receipts and payments in short period. It
includes the value of export and imports of both visible and invisible goods. There can be either
surplus or deficit in current account. The current account includes:- export & import of
services, interests, profits, dividends and unilateral receipts/payments from/to abroad. BOP on
current account refers to the inclusion of three balances of namely – Merchandise balance,
Services balance and Unilateral Transfer balance
 Types of Balances

Trade Balance

Merchandise: exports - imports of goods

Services: exports - imports of services

Income Balance

Net investment income: net income receipts from assets

Net international compensation to employees: net compensation of Employees

Net Unilateral Transfers

Gifts from foreign countries minus gifts to foreign countries

2. Capital Account Balance

The capital account records all international transactions that involve a resident of the country
concerned changing either his assets with or his liabilities to a resident of another country.
Transactions in the capital account reflect a change in a stock – either assets or liabilities. It is
difference between the receipts and payments on account of capital account. It refers to all
financial transactions. The capital account involves inflows and outflows relating to
investments, short term borrowings/lending, and medium term to long term borrowing/lending.
There can be surplus or deficit in capital account. It includes private foreign loan flow,
movement in banking capital, official capital transactions, reserves, gold movement etc. These
are classifies into two categories

 Direct foreign investments

 Portfolio investments
 Other capital

There are mainly 3 types of Foreign Investments namely, Foreign Direct Investment, Foreign
Portfolio Investment, Foreign Institution Investment.

Foreign Direct Investment: Foreign direct investment (FDI) is an investment from a party in
one country into a business or corporation in another country with the intention of establishing
a lasting interest. Lasting interest differentiates FDI from foreign portfolio investments, where
 investors passively hold securities from a foreign country. A foreign direct investment can be
made by obtaining a lasting interest or by expanding one’s business into a foreign country.

Foreign Portfolio Investment: Foreign portfolio investment (FPI) refers to the purchase of
securities and other financial assets by investors from another country. Examples of foreign
portfolio investments include stocks, bonds, mutual funds, exchange traded funds, American
depositary receipts (ADRs), and global depositary receipts (GDRs).

Foreign Institutional Investment: A foreign institutional investor (FII) is an investor or

investment fund investing in a country outside of the one in which it is registered or
headquartered. The term foreign institutional investor is probably most commonly used in
India, where it refers to outside entities investing in the nation's financial markets.

3. Errors & Omissions

The entries under this head relate mainly to leads and lags in reporting of transactions. It is of
a balancing entry and is needed to offset the overstated or understated components.

2.3 DISEQUILIBRIUM IN THE BALANCE OF PAYMENTS

A disequilibrium in the balance of payment means its condition of Surplus or deficit. A Surplus
in the BOP occurs when Total Receipts exceeds Total Payments. Thus, BOP=
CREDIT>DEBIT. A Deficit in the BOP occurs when Total Payments exceeds Total Receipts.
Thus, BOP= CREDIT<DEBIT

Causes of Disequilibrium in the BOP

Economic Factors

1. Imbalance between exports and imports

2. Large scale development expenditure which causes large imports
3. High domestic prices which leads to imports
4. Cyclical fluctuation in general business activities

Political Factors

1. Political Instability may experience large capital outflow and inadequacy of domestic
investment and production
2. Factors like war, change in world trade route
 Social Factors

1. Change in fashion, taste and preference of the people bring disequilibrium in BOP by
influencing imports and exports
2. High population growth

2.4 METHODS TO CORRECT BOP DISEQUILIBRIUM

1. Monetary Measures :-
a) Monetary Policy: The monetary policy is concerned with money supply and
credit in the economy. The Central Bank may expand or contract the money
supply in the economy through appropriate measures which will affect the
prices.
b) Fiscal Policy Fiscal policy is government's policy on income and expenditure.
Government incurs development and non - development expenditure. It gets
income through taxation and non - tax sources. Depending upon the situation
government’s expenditure may be increased or decreased.
c) Exchange Rate Depreciation: By reducing the value of the domestic currency,
government can correct the disequilibrium in the BoP in the economy.
Exchange rate depreciation reduces the value of home currency in relation to
foreign currency. As a result, import becomes costlier and export become
cheaper. It also leads to inflationary trends in the country,
d) Devaluation: Devaluation is lowering the exchange value of the official
currency. When a country devalues its currency, exports becomes cheaper and
imports become expensive which causes a reduction in the BOP deficit.
e) Deflation: Deflation is the reduction in the quantity of money to reduce prices
and incomes. In the domestic market, when the currency is deflated, there is a
decrease in the income of the people. This puts curb on consumption and
government can increase exports and earn more foreign exchange.
f) Exchange Control: All exporters are directed by the monetary authority to
surrender their foreign exchange earnings, and the total available foreign
exchange is rationed among the licensed importers. The license-holder can
import any good but amount if fixed by monetary authority.
 2. Trade Measures:
a) Export Promotion To control export promotions the country may adopt
measures to stimulate exports like:
 Export duties may be reduced to boost exports, cash assistance,
subsidies can be given to exporters to increase exports
 Goods meant for exports can be exempted from all types of taxes.
b) 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 these import substitutes.
c) Import Control: Import may be kept in check through the adoption of a wide
variety of measures like quotas and tariffs. Under the quota system, the
government fixes the maximum quantity of goods and services that can be
imported during a particular time period.
 Quotas – Under the quota system, the government may fix and permit
the maximum quantity or value of a commodity to be imported during a
given period. By restricting imports through the quota system, the deficit
is reduced and the balance of payments position is improved.
 Tariffs – Tariffs are duties (taxes) imposed on imports. When tariffs are
imposed, the prices of imports would increase to the extent of tariff. The
increased prices will reduced the demand for imported goods and at the
same time induce domestic producers to produce more of import
substitutes
3. Miscellaneous Measures:
a) Loan in foreign currencies
b) Attracting Foreign Investment
c) Attracting NRI Deposits
d) Development of Tourism

2.5 EXCHANGE RATE

An exchange rate is the value of one nation's currency versus the currency of another nation
or economic zone. The exchange rate of a currency is how much of one currency can be
bought for each unit of another currency. Currencies are traded in the foreign exchange
market. Like any other market, when something is exchanged there is a price. In the foreign
 exchange market, a currency is being bought and sold, and the price of that currency is given
in some other currency. That price is expressed as an exchange rate. A currency appreciates
if it takes more of another currency to buy it, and depreciates if it takes less of another
currency to buy it. Currency appreciation is when a currency becomes more valuable relative
to another currency; a currency appreciates when you need more of another currency to buy
a single unit of a currency. Currency depreciation is when the value of a currency decreases
relative to another currency; a currency depreciates when you need less of another currency
to buy a single unit of a currency. When an exchange rate changes, the value of one currency
will go up while the value of the other currency will go down. When the value of a currency
increases, it is said to have appreciated. On the other hand, when the value of a currency
decreases, it is said to have depreciated.
There are various types of exchange rates that are prevalent in the market, but the most
commonly used exchange rate systems are fixed exchange rate and flexible exchange rate
systems.
2.6 FIXED EXCHANGE RATE SYSTEM AND FLOATING EXCHANGE RATE
SYSTEM
There are various types of exchange rates that are prevalent in the market, but the most
commonly used exchange rate systems are fixed exchange rate and flexible exchange rate
systems. Fixed exchange rate system is referred to as the exchange system where the
exchange rate is fixed by the government or any monetary authority. It is not determined by
the market forces. Flexible exchange rate system is the exchange system where the exchange
rate is dependent upon the supply and demand of money in the market. In a flexible exchange
rate system, the value of the currency is allowed to fluctuate freely as per the changes in the
demand and supply of the foreign exchange.

Fixed or Pegged Exchange Rate System

A fixed exchange rate is a regime applied by a government or central bank that ties the
country's official currency exchange rate to another country's currency or the price of gold.
The purpose of a fixed exchange rate system is to keep a currency's value within a narrow
band. Fixed rates provide greater certainty for exporters and importers. Fixed rates also help
the government maintain low inflation, which, in the long run, keep interest rates down and
stimulates trade and investment. Most major industrialized nations have had floating
exchange rate systems, where the going price on the foreign exchange market (forex) sets its
currency price. If the rate of exchange diverges from the fixed equilibrium level due to market
forces or the activities of speculators, the monetary authority or government interferes in the
foreign exchange market and maintains the rate of exchange at the equilibrium level. The
market intervention in such a situation is called as pegging, i.e., the sale or purchase of foreign
exchange in the foreign exchange market. The authorities buy the foreign exchange when
there is excess supply of it and sell it out when there is excessive demand for it in the exchange
market. The pegging operations facilitate the maintenance or ‘pegging’ of the rate of
exchange at the desired equilibrium level.

The fixed or pegged rate of exchange can be shown in the above diagram. The amount of
foreign currency is measured along the horizontal scale and the rate of exchange is measured
along the vertical scale. In Diagram Panel (a), the equilibrium fixed official rate of exchange
is R0 determined by the intersection between the demand and supply function D and S
respectively. If the demand for foreign currency increases such that the demand function shifts
from D to D1, given the exchange rate, there is excess demand gap which is likely to
appreciate the exchange value of foreign currency in terms of domestic currency to R 1 or
cause corresponding depreciation in the exchange value of domestic currency. In order to peg
or maintain the exchange rate at R0, the excess demand gap AB is neutralized through the sale
of foreign currency in the foreign exchange market.
In Diagram Panel (b), the fixed official rate of exchange is again R 0. If there is an increase in
the supply of foreign currency due to BOP surplus, the supply curve shifts to the right from
S to S1. This creates an excess supply gap A1B1. Consequently, the exchange value of foreign
currency in terms of domestic currency depreciates to R2 or there is a corresponding
appreciation in the exchange value of domestic currency. In order to peg or maintain the
exchange rate at the official level R0, the government or monetary authority will be obliged
 to buy the foreign currency in the exchange market. Thus in a system of fixed exchange rates,
the pegging operations (sale or purchase of foreign currency) can help maintain the
equilibrium rate of exchange at the official level.

Flexible or Fluctuating Exchange Rate System

The flexible or fluctuating exchange rates are determined by the free working of the market
forces. If there is an excess of demand for foreign currency over its supply, the foreign currency
appreciates whereas the home currency depreciates. On the opposite, when the supply of
foreign currency exceeds the demand for it, the foreign currency depreciates and the exchange
value of home currency appreciates in terms of the foreign currency. Thus there are appropriate
variations in the exchange rates to maintain the BOP equilibrium.

The impact of changes in demand for and supply of foreign currency upon the rate of exchange
and consequent effect on the BOP adjustments can be shown through above diagrams. In
diagrams, the amount of foreign currency is measured along the horizontal scale and rate of
exchange is measured along the vertical scale. In Diagram Panel (a), given the demand and
supply functions of foreign currency D and S, the initial equilibrium rate of exchange is R 0. If
demand increases and demand function shifts to the right to D 1, there is excess demand for
foreign currency at R0 rate of exchange. The excess demand pressure causes an appreciation of
foreign currency to R1 (depreciation of home currency). This movement of exchange rate
restores the balance of payments in an automatic manner. On the opposite, if a decrease in the
demand for foreign currency causes a shift in the demand function to D2, there is deficiency of
demand for foreign currency at R0 rate. As a result, the foreign currency depreciates to
R2 (appreciation of home currency). This movement of rate of exchange neutralizes any
possibility of BOP surplus and keeps the system in a state of balance.
 In Diagram Panel (b), the original equilibrium rate of exchange is R 0. If there is an increase in
supply of foreign currency, the supply function shifts to the right to S 1 causing depreciation in
foreign currency R1 (appreciation of home currency). On the opposite, a decrease in supply
causes a shift in the supply function to the left to S2. There is shortage of the foreign currency
at the original rate. It leads to an appreciation of foreign exchange upto R2 (depreciation of
home currency). Whether there is a BOP deficit or surplus, it can be easily and rapidly offset
by the free movement of the exchange rates. The monetary or fiscal authorities are not required
to intervene to correct the BOP disequilibrium. The market forces of demand and supply
operate in an automatic way and no need is felt for making accommodating capital transactions
for achieving or maintaining the BOP equilibrium. The flexible exchange rates are also called
as floating exchange rates.
Difference between Fixed Exchange Rate and Floating Exchange Rate
Fixed Rate Flexible Exchange Rate
Definition
Fixed rate is the system where the government Flexible exchange rate is the system which is
decides the exchange rate dependent on the demand and supply of the
currency in the market
Deciding authority
Fixed rate is determined by the central Flexible rate is determined by demand and
government supply forces
Impact on Currency
Currency is devalued and if any changes take Currency appreciates and depreciates in a
place in the currency, it is revalued. flexible exchange rate
Involvement of Government Bank
Government bank determines the rate of No such involvement of government bank
exchange
Need for maintaining foreign reserve
Foreign reserves need to be maintained No need for maintaining foreign reserve
Impact on BOP (Balance of Payment)
Can cause deficit in BOP that cannot be Deficit or surplus in BOP is automatically
adjusted corrected

2.7 EURO-DOLLAR MARKET

Though the emergence of Euro-dollar in the international financial system is of recent origin,
in the late sixties, it has caused a profound influence upon the money and capital markets of
the Western world. Presently, however, the Euro-dollar Market has become a permanent
integral part of the international monetary system. Euro-dollar market is the creation of the
international bankers. It is simply a short-term money market facilitating banks’ borrowings
and lendings of U.S. dollars. The Euro-dollar market is principally located in Europe and
basically deals in U.S. dollars.

But, in a wider sense, Euro-dollar market is confined to the external lending and borrowing of
the world’s most important convertible currencies like dollar, pound, sterling, Swiss franc,
French franc, Deutsche mark and the Netherlands guilder. In short, the term Euro-dollar is used
as a common term to include the external markets in all the major convertible currencies.

By Euro-dollar is meant all U.S. dollar deposits in banks outside the United States, including
the foreign branches of U.S. banks. A Euro-dollar is, however, not a special type of dollar. It
bears the same exchange rate as an ordinary U.S. dollar has in terms of other currencies. Euro-
dollar transactions are conducted by banks not resident in the United States. For instance, when
an American citizen deposits (lends) his funds with a U.S. Bank in London, which may again
be used to make advances to a business enterprise in the U.S., then such transactions are
referred to as Euro-dollar transactions. All Euro-dollar transactions are, however, unsecured
credit.

Euro-dollars have come into existence on account of the Regulation issued by the Board of
Governors of the U.S. Federal Reserve System, which does not permit the banks to pay interest
to the depositors above a certain limit. As such, banks outside the United States tend to expand
their dollar business by offering higher deposit rates and charging lower lending rates, as
compared to the banks inside the U.S. Increase or decrease in the potential for Euro-dollar
holdings, however, depends, directly upon U.S. deficits and surplus, respectively. Euro-dollar
operations are unique in character, since the transactions in each currency are made outside the
country where that currency originates. The Euro-dollar market attracts funds by offering high
rates of interest, greater flexibility of maturities and a wider range of investment qualities.
Though Euro-dollar market is wholly unofficial in character, it has become an indispensable
part of the international monetary system. It is one of the largest markets for short-term funds.

The Euro-dollar market has the following characteristics:

1. It has emerged as a truly international short-term money market.

 2. It is unofficial but profound.

3. It is free.

4. It is competitive.

5. It is a more flexible capital market.

Original customers of the Euro-dollar market were the business firms in Europe and the Far
East which found Euro-dollars a cheaper way of financing their imports from the United States,
since the lending rates of dollars in the Euro-dollar market were relatively less.

The Euro-dollar market has two facts:

1. It is a market which accepts dollar deposits from the non-banking public and gives
credit in dollars to the needy non-banking public
2. It is an inter-bank market in which the commercial banks can adjust their foreign
currency position through inter-bank lending and borrowing.
The existence of Euro-dollar market in a country, however, depends on the freedom given to
the commercial banks to hold, borrow and lend foreign currencies — especially dollars — and
to exchange them at fixed official exchange rate.

Benefits of the Euro-Dollar Market:

The benefits of Euro-Dollar Market is given below
1. It has provided a truly international short-term capital market, owing to a high degree
of mobility of the Euro-dollars.

2. Euro-dollars are useful for the financing of foreign trade.

3. It has enabled the financial institutions to have greater flexibility in adjusting their cash
and liquidity positions.

4. It has enabled importers and exporters to borrow dollars for financing trade, at cheaper
rates than otherwise obtainable.

5. It has helped in reducing the profit margins between deposit rates and lending rates.

6. It has enhanced the quantum of funds available for arbitrage.

 7. It has enabled monetary authorities with inadequate reserves to increase their reserves
by borrowing Euro-dollar deposits.

8. It has enlarged the facilities available for short-term investment.

9. It has caused the levels of national interest rates more akin to international influences.

Drawbacks of the Euro-Dollar Market:

The major drawbacks of the Euro-dollar market may be mentioned as under:
1. It may lead banks and business firms to overtrade.

2. It may weaken discipline within the banking communities.

3. It involves a grave danger of sudden large- scale withdrawal of credits to a country.

4. It has rendered official monetary policies less effective for the countries involved.

In fact, the Euro-dollar market has created two major problems for an individual country
dealing in it. Firstly, there is the danger of over-extension of the dollar credit by domestic banks
of the country; consequently, high demand pressure on the official foreign exchange may take
place

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