Balance of Payments | Chapter 5 Notes

Balance Of Payment (BOP)

Balance of payment is a statement which records all the monetary transactions made by any country’s individuals, corporates and the government with the rest of the world over a defined period of time.

The balance of payments (BOP) is also known as the balance of international payments.

These transactions consist of imports and exports of goods, services, and capital, as well as transfer payments, such as foreign aid and remittances.

A country’s balance of payments and its net international investment position together constitute its international accounts.

When all the elements are correctly included in the BOP, it should sum up to zero. This reveals that inflows and outflows of funds should balance out. 

The balance of payments includes both the current account and capital account.

A country’s BOP is vital for the following reasons:

  • It reveals its financial and economic status.
  • It can be used as an indicator to determine whether the country’s currency value is appreciating or depreciating.
  • It helps the Government to decide on fiscal and trade policies.
  • It provides important information to analyze and understand the economic dealings of a country with other countries.
  • By studying its BOP statement one would be able to identify trends that may be beneficial or harmful to the economy of the county and thus, then take appropriate measures.

Components Of Balance of Payment

Balance of payments, current account, capital account, financial accounts

There are three components of balance of payment viz current account, capital account, and financial account. The total of the current account must balance with the total of capital and financial accounts in ideal situations.

Current Account

The current account includes a nation’s net trade in goods and services with other countries, its net earnings on cross-border investments, and its net transfer payments.

It is used to monitor the inflow and outflow of goods and services with other countries. 

This current account covers all the receipts and payments made with respect to raw materials and manufactured goods.

It includes receipts from engineering, tourism, transportation, business services, stocks, and royalties from patents and copyrights. 

When all the goods and services are combined together they make up a country’s Balance Of Trade (BOT).

There are various categories of trade and transfers which happen across countries. It could be visible or invisible trading, unilateral transfers or other receipts. 

Trading in goods between countries are referred to as visible items and exchange of services like banking, information technology etc. are referred to as invisible items.

Unilateral transfers refer to money sent as gifts or donations or to residents of foreign countries or personal transfers like money sent by relatives to their family located in another country.

Capital Account

All capital transactions between the countries are monitored through the capital account. Capital transactions include the purchase and sale of assets like land and properties.

This capital account also includes the flow of taxes, purchase and sale of fixed assets etc by migrants moving out to a different country. 

The deficit or surplus in the current account is managed through the finance from the capital account and vice versa. 

There are three major elements of a capital account:

? Loans and borrowings: It includes all types of loans from both the private and public sectors located in foreign countries.

? Investments: These are funds invested in the corporate stocks by non-residents.

? Foreign exchange reserves: Held by the central bank of a country to monitor and control the exchange rate does impact the capital account.

Financial Account

The to and fro of funds from foreign countries through various investments in real estates, business ventures, foreign direct investments etc is monitored through the financial account. 

Financial account measures the changes in the foreign ownership of domestic assets and domestic ownership of foreign assets. 

From these measures we can understand whether the country is selling or acquiring more assets like gold, stocks, equity etc.

Difference Between Current Account And Capital Account 

Capital Account

  • The capital account consists of a nation’s transactions in financial instruments and central bank reserves.
  • The capital account, broadly defined, includes transactions in financial instruments and central bank reserves.

Current Account

  • The current account includes transactions in goods, services, investment income, and current transfers.
  • The current account is included in calculations of national output, while the capital account is not.

A Balance of Payment statement of any country indicates whether the country has a surplus or a deficit of funds. 

If a country’s export is more than its import, its BOP is said to be in surplus. On the other hand, the BOP deficit indicates that a country’s imports are more than its exports.

Tracking the BOP statement is something similar to the double entry system of accounting. This means, all the transactions will have a debit entry and a corresponding credit entry.

Foreign Exchange Rate 

A foreign exchange rate is the rate at which one national currency will be exchanged for another. It is also regarded as the value of one country’s currency in relation to another currency.

A currency may be floating or fixed (pegged)

Governments can impose certain limits and controls on exchange rates.

In floating exchange rate regimes, exchange rates are determined in the foreign exchange market, which is open to a wide range of different types of buyers and sellers, this currency trading is continuous for 24 hours a day except weekends. 

In the retail currency exchange market, different buying and selling rates will be quoted by money dealers. Most trades are to or from the local currency. 

The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell that currency. 

Foreign Exchange

It is the trading of one currency for another. This exchange can take place on the foreign exchange market, also known as the forex market.

The forex market is the largest and most liquid market in the world, with trillions of dollars changing hands every day. There is no centralized location of this market.

This market is an electronic network of banks, brokers, institutions, and individual traders 

For trading currencies, there are list of pairs in which anyone can trade, such as USD/CAD, EUR/USD, USD/JPY or USD/INR etc. 

There is a price associated with each pair, such as Rs 75 is equal to one US dollar, it means that it costs Rs 75 (current INR rate) to buy one USD. 

When you are making any trades in the forex market, you’re basically buying or selling the currency of a particular country. But there is no physical exchange of money from one hand to another. 

Fixed Exchange Rate And Flexible Exchange Rate 

There are various types of exchange rates that are prevalent in the market, like 

  • Fixed Rate
  • Flexible Rate
  • Forward Rate
  • Spot Rate
  • Dual Rate 

Most commonly used exchange rate systems are fixed exchange rate and flexible exchange rate systems.

Fixed Exchange Rate

Fixed exchange rate is a system where the exchange rate is fixed by the government or any monetary authority and maintains as the official exchange rate. It is not determined by the market forces.

A set exchange rate will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen, etc.)

In order to maintain the local exchange rate, the central bank (RBI) buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.

Central bank determined that the value of a single unit of local currency is equal to US Dollar. In order to maintain the rate, the central bank must keep a high level of foreign reserves. The central bank can also adjust the official exchange rate when necessary.

Flexible Exchange Rates

Flexible exchange rate system, also called floating rate, 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 depending on changes in the demand and supply of the foreign exchange.

A flexible exchange rate is determined by the private market through supply and demand. 

If demand for any currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. 

This generate more jobs, causing an auto-correction in the market. A floating exchange rate is constantly changing.

The fact of the matter is, no currency is fully fixed or floating. In a fixed regime, market pressures may influence changes in the exchange rate. 

Sometimes, when a local currency reflects its true value against its pegged currency, a “black market” may develop. By keeping this in mind a central bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the unofficial one, thereby halting the activity of the black market.

Difference Between Fixed Rate And Flexible Rate

Fixed RateFlexible Rate
It is determined by the central governmentIt is determined by demand and supply forces
Currency is devalued and if any changes take place in the currency, it is revalued.Currency appreciates and depreciates in a flexible exchange rate
Government bank determines the rate of exchangeNo such involvement of government bank
Foreign reserves need to be maintainedNo need for maintaining foreign reserve
Can cause deficit in BOP that cannot be adjustedDeficit or surplus in BOP is automatically corrected

Determination Of Exchange Rate In a Free Market.

Exchange rate in a free exchange market is determined where demand for foreign exchange is equal to the supply of foreign exchange.

The value of currency of each country in terms of the other currency depends upon the demand for and supply of their currencies.

Less foreign exchange is demanded when the exchange rate increases. Rise in price of foreign exchange increases the rupee cost of foreign goods, which make them more expensive. As a result, imports decline. Thus, the demand for foreign exchange also decline.

The supply of foreign exchange increases as the exchange rate increases. This makes home goods cheaper to foreigners since rupee is depreciating in value. The demand for our exports should therefore also increase as the exchange rate increases.

The increased demand for our exports means greater supply of foreign exchange. Thus, the supply of foreign exchange increases as the exchange rate increases.


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Frequently Asked Questions

Q1. What Is the Balance of Payments (BOP)?

Answer: Balance Of Payment (BOP) is a statement which records all the monetary transactions made by any country’s individuals, corporates and the government with the rest of the world over a defined period of time.

Q2. What is fixed exchange rate?

Answer: Fixed exchange rate is a system where the exchange rate is fixed by the government or any monetary authority and maintains as the official exchange rate. It is not determined by the market forces.

Q3. What is flexible exchange rate?

Answer: Flexible exchange rate system, also called floating rate, is the exchange system where the exchange rate is dependent upon the supply and demand of money in the market.

Balance of Payments Unit 5 CBSE, class 12 Economics notes. This cbse Economics class 12 notes has a brief explanation of every topic that NCERT syllabus has.

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