Balance of Payments notes | Class 12 economics notes

Table of Contents

Chapter – 5: Balance of Payments (6 to 10 Marks)

Short and Long Answer Type Questions

Q.1. What is Fixed Exchange Rate? Mention its merits and demerits. 2015

Ans: Fixed exchange rate which is officially fixed in term of gold or any other currency by the government. Fixed exchange rate promotes international trade.

Merits of Fixed Exchange Rate:

Promotes International Trade: Fixed exchange rates ensure certainty about the foreign payments and hence help to promote international trade.
Promotes International Investment: Fixed exchange rates promote international investments. They encourage long term capital flows.
No Fear of Speculation: Under fixed exchange rate system, there is any fear of speculation on the exchange rate.

Demerits of Foreign Exchange Rate:

Large Reserves of Foreign Currencies: Under the system of fixed exchange rates, large reserves of foreign currencies are required to be maintained to avoid devaluation.
Pegged Rates are not Permanently Fixed: Fixed (pegged) exchange rates are not permanently fixed. Countries with deficits in BOP may be forced to devalue their currency.
Sacrifice of the Objective of Full Employment and Stable Prices: Under the system of fixed exchange rate, the objectives of full or high level of employment and price stability at home are sacrificed at the cost of external stability.

Q.2. What is flexible exchange rate? Mention its merits and demerits.

Ans: Flexible exchange rate is that rate which is determined by the forces of demand and supply of foreign exchange.

Merits of Flexible Exchange Rate:

No Need for Foreign Exchange Reserves: There is no need for the government to hold foreign exchange reserves. A deficit country will simply allow its currency to depreciate in relation to foreign currency instead of supply foreign exchange reserves to other country to maintain a stable exchange rate.
Simple in Operation: A system of flexible exchange in simple in its operation. It eliminates the problem of overvaluation or undervaluation of currencies.
Autonomy of the Domestic Monetary Policy: Under flexible exchange rate system, a country is free to adopt independent monetary policy. Countries, therefore, are not required to sacrifice the objectives of full employment and economic growth in order to correct BOP disequilibrium.
Exchange Controls not required: This system does not require the use of exchange control which is generally associated with the system of pegged rates.

Demerits of Flexible Exchange Rate

Unstable Conditions: Flexible exchange rates create conditions of instability and uncertainty in the economy. Wide fluctuations in exchange rates tend to reduce the volume of international trade and foreign investment.
Inflationary Bias: Another disadvantage of the flexible exchange rates is that they have an inflationary impact of the economy. Whenever there is deficit in BOP, the currency depreciates.

Q.3. Distinguish between flexible foreign exchange rate and fixed foreign exchange. 2016

Ans: Following are the differences between flexible foreign exchange rate and fixed foreign exchange rate in the content of foreign trade.

Flexible exchange rate is determined by the forces of demand and supply of foreign exchange. On the other hand, the fixed exchange rate is determined automatically through the working of the economic system by the government.
Under flexible exchange rate it is free to fluctuate according to change in demand and supply of foreign currency. On the other hand, under fixed exchange rate system, only the govt. has the power to change it.
Under flexible exchange rate, the exchange rate is frequently changed. On the other hand, in the fixed exchange rate system, changes of exchange rate come when there is disequilibrium in balance of payment.
Under flexible exchange rate, it creates situations of instability and uncertainty. On the other hand, under fixed exchange rate system, it ensures stability in exchange rate.
Under flexible exchange rate it eliminated the problem of overvaluation or undervaluation of currency. On the other hand, under fixed exchange rate there may be undervaluation or overvaluation of currency.

Q.4. Explain how the equilibrium price of a foreign currency is determined in foreign exchange market?

Ans: Foreign exchange market is the market where currencies of different countries are traded for one another at a foreign exchange rate. Foreign exchange rate refers to the rate at which the currency of one country is exchanged, with the currency of another country. Like other prices, the rate of exchange is also determined in accordance with the general theory of value that is by the interaction of the forces of demand and supply if rate is fluctuating. But in case of fixed exchange, rate is determined by the government.

If the demand for foreign exchangeable currency increases, then the new exchange rate indicates devaluation of domestic currency. As a result of increasing price of foreign currency, more domestic currency is spent while purchasing foreign goods. Consequently, import falls, resulting to fall of demand for money. Again, if the supply of foreign exchange increases then elasticity of demand for produced goods within the country must be greater than one. Under this situation, quantity of foreign currencies increases through export. Hence, demand and supply determined the price of equilibrium foreign exchange rate.

Q.5. Explain how exchange rate is determined in a system of flexible exchange rate.

Ans. Flexible exchange rate is that rate which is determined by the forces of demand and supply of foreign exchange. In case of flexible exchange rate, the central banks do not intervene.

In the given diagram, DD, D₁D₁ and D₂D₂ represents demand for foreign exchange and SS curve represents the supply of foreign currencies. There is an inverse relation between foreign exchange rate and demand for foreign exchange. Graphically, the demand curve of foreign exchange is downward sloping indicating that there is an inverse relationship between foreign exchange rate and demand for foreign exchange. But there is a direct relation between foreign exchange rate and supply of foreign exchange. Higher the exchange rate, higher the supply of foreign exchange and lower the exchange rate, lower the supply of foreign exchange.

Q.6. Explain briefly various determinants of exchange rate under flexible exchange rate system.

Ans: Under flexible exchange rate the factors that influence the exchange rate between the currencies of two countries. Besides from export and import the following factors play a vital role in the determination of flexible exchange rate.

Speculation: Money is considered as an asset in every country. If the demand for foreign exchange increases, supply schedule remains same, the exchange rate will rise. If the speculators expect to fall in the value of currency in the near future, they will sell the currency and start buying the other currency they expect to appreciate in value.
Interest Rate: In the short run, another factor determining the exchange rate movement is the interest rate differential. If the bank rate rises relative to other countries, more funds will flow into the country from abroad to earn high interest rate. It will lead to raise the demand for the domestic currency and the exchange rate will move in favour of the country.
Income: When the income of consumer increases, consumer can spend more things than before. So, spending on imported goods will also increase which led rightward shifts of demand curve for foreign exchange. As a result, the domestic currency depreciates.

Q.7. What are the main sources of demand for foreign exchange?

Ans: Following are the main sources of demand for foreign exchange:

To purchase goods and services from other countries by the domestic residents.
To send gifts and grants to foreign countries.
To speculate on the value of foreign currencies.
To make payments of international loans.

Q.8. What are the main sources of supply of foreign exchange?

Ans: Following are the sources of supply of foreign exchange:

Foreigner’s purchasing domestic country’s goods and services through exports.
Direct foreign investment in the domestic country.
Flow of foreign exchange due to speculative purchases by the non-residents in the domestic country.
Remittances by the non-residents living abroad.

Q.9. Describe the role of speculation in determining the flexible rate of exchange.

Ans: Flexible exchange rate is determined by the forces of demand and supply of foreign exchange. The growth of speculative activities also influences the exchange rate. Money is important for determining the flexible exchange rate. The increasing value of foreign currency increases the demand for money. If the value of yen is increased then Indians will want to hold more yen. This expectation would increase the demand for yen and this increased demand will raise the rupee-yen exchange rates at present.

Q.10. What is open and closed economy? Distinguish between an open economy and closed economy.

Ans: An open economy means that traders of goods and services and financial assets with other countries.

Closed economy is one that does not trade with other nations in goods and services and financial assets with other countries.

Differences between open and closed economy are as follows:

In an open economy there are needs of foreign currency. On the other hand in a closed economy domestic currency is needed for exchange.
The aggregate demand curve of the open economy is flatter then the aggregate demand curve of the closed economy.
In an open economy, saving may not be equal to investment. On the other hand, in a closed economy saving is always equal to investment.
In an open economy, the demand for domestic goods is equal to the domestic goods plus exports minus imports. On the other hand, in an closed economy, there are three sources of demand for domestic goods – Consumption, Govt. spending, Domestic investment.

Q.11. Distinguish between autonomous and accommodating transactions of balance of payment. 2015

Ans: Following are the differences between autonomous and accommodating transactions and balance of payments.

The items that are included in a particular balance are placed below the line are called accommodating items. On the other hand the items that are put above the line are called autonomous items.
Accommodating transactions are determined by the new consequence of autonomous transaction. On the other hand, autonomous transactions are referring those transactions which are made independently of the state of the balance of payment.

Q.12. What is Balance of Payments (BOP)? What are two components of BOP? Explain and distinguish between them.

Ans: The Balance of Payments (BOP) of a country is a systematic record of all economic transactions between the residents of a country and the rest of the world. It is composed 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, services received and capital transferred to non-residents or foreigners. There are two components of BOP:

Current Account
Capita Account

Current Account: Current account is that account of BOP which records imports and exports of goods and services and unilateral transfers. Current account deals with currently produced goods and services. Current account transactions are called account of actual transaction, because all the items included in it are actually transacted. It thus, records the following items:

Exports and Import of Visible Items or Goods.
Invisible Items (or Non-Material Goods or Services).
Unilateral Transfers.

Capital Account: Capital account is that account of BOP which records all such transactions between the residents of a country and rest of the world which cause a change in the asset or liability of the country. It concerns with capital transactions – all kinds of short term and long term international capital transfers, gold and sale/purchase of assets. It also deals with the payments of debts and claims. Main items of capital account are listed below:

Direct Investment.
Portfolio Investment.
Banking Capital Transactions.

Difference between Current Account and Capital Account of BOP: The main points of difference between current account and capital accounts are as follows:

Current account records economic transactions relating to exchange of goods and services and unilateral transfers while capital account records capital transaction, e.g. borrowing and lending, sale and purchase of assets, change in the stock of gold and foreign exchange.
Current account transactions are of flow nature, while capital transactions are of stock nature.
Current account transactions bring about a change in the current level of a country’s income, whereas capital transactions bring about a change in the capital stock of a country.

Q.13. Distinguish between balance of payment and balance of trade. 2014, 2016

Ans: Following are the differences between balance of payment and balance of trade:

Basis	Balance of Trade	Balance of Payments
Meaning	The balance of exports and import of the product and services is termed as Balance of Trade.	The balance of payments of a country is a systematic record of all its economic transactions with the outside world in a given year.
Recording of transactions	It records transactions relating to goods only.	It records transactions relating to both goods and services.
Capital transfer	Capital transfers are not included in balance of trade.	Capital transfers are included in balance of payment.
International transactions	Balance of trade gives a partial picture of the international transactions of a country.	Balance of payment gives a full picture of the international transactions of a country.
Component	It is a component of current account of balance of payment.	It has two components – capital account and current account.
Result	It can be favourable, unfavourable and balanced.	Both the receipts and payments side tallies.

Q.14. What is Disequilibrium in Balance of Payments? Explain various causes behind deficit in BOP. 2015, 2017, 2019

Ans: Disequilibrium in Balance of Payments: Balance of payments always balances in the accounting sense. The overall account of the balance of payments necessarily balance or must always be in equilibrium. It is because of the reason that balance of payment is prepared in terms of credits and debits based on the system of double entry book-keeping. Under the system, the two sides are kept equal.

Causes behind Deficit in BOP: Deficit in BOP is caused by a variety of factors which is given below:

Huge Development Expenditure: When a backward country starts various development schemes often needs the imports of machines, raw materials, etc. This raises the country’s import bill and consequently its BOP becomes adverse.
Population Growth: A country with a high rate of growth of population often faces an adverse balance of payments because the total demand for goods and services within the country cannot be met out of domestic production.
Inflation: Inflation may also cause deficit in the balance of payments; Exports decrease as a result of inflation and at the same time the demand for imports increases.
Change in Foreign Exchange Rates: When the external value of the domestic currency goes up, imports become cheaper and exports dearer.