Open Economy Macroeconomics Class 12 Notes Economics Part B Chapter 6

Lesson at a Glance

Foreign Exchange Rate: The rate at which currency of one country can be exchanged for currency of another country is called the rate of foreign exchange. In other words, it is the price paid in domestic currency in order to get one unit of foreign currency. In case of an international payment,currency of one country has to be converted into the currency of another country because every country wants the payment in its own currency. Suppose, if an American firm exports goods to India, it wants to receive the payment in dollars. As a result of this, Indian importer will have to covert Indian Rupees into American dollars.

Fixed Exchange Rate System: It refers to a system in which exchange rate for a currency is fixed by the government. The basic purpose of adopting this system is to ensure stability in foreign trade and capital movements. Only a very small deviation from this fixed value is possible. To achieve stability, government undertakes to buy foreign currency when the exchange rate becomes weaker and sell foreign currency when the rate of exchange gets stronger. Historically, it has two variants:

(a) Gold Standard system: According to this system, gold was taken as the common unit of parity between currencies of different countries in circulation. Each country was to define value of its currency in terms of gold. Accordingly,value of one currency in terms of the other currency was fixed considering gold value of each currency. This system was also known as Mint par value of exchange or Mint parity. It was prevalent in most countries prior to 1920s.For example: if €1 = 5 gm of gold and \$1 = 2 gm of gold, then exchange rate will be €1 = \$2.5.

(b) Bretton Woods System: According to this system, gold was replaced by US dollar as the ‘core’ of the system.Under this system, all currencies were pegged or related to US dollar at a fixed exchange rate. US dollar was assigned gold value at a fixed price.

• Flexible/Floating Exchange Rate System: Flexible rate of exchange is that rate which is determined by the demand for & supply of the currencies concerned in the foreign exchange market. In other words, it is determined by the market forces, like the price of any other commodity. Here, value of currency is allowed to fluctuate or adjust freely according to change in demand and supply of foreign exchange. There is no official intervention in foreign exchange market. The rate at which demand for foreign currency is equal to its supply is called ‘par rate of exchange’.

• Managed Floating Rate System: It refers to a system in which foreign exchange rate is determined by market forces and central bank is a key participant to stabilize the currency in case of extreme depreciation or appreciation. It is also known as ‘dirty floating’. In this system, central bank intervenes to restrict fluctuations in the exchange rate within certain limits. The aim is to keep exchange rate close to desired target values.

• Spot market: This market handles only spot transactions or current transactions. In other words, market in which receipts & payments are made immediately is known as spot market.The rate of exchange which is determined in the spot market is known as spot rate of exchange. Spot market is of daily nature and does not deal in future deliveries.

• Forward market: This market handles such transactions of foreign exchange as are meant for future delivery. In other words, in this type of market, sale and purchase of foreign currency is settled on a specified future date at a rate agreed upon today. The rate is settled now but actual transaction of foreign exchange takes place in future. The exchange rate quoted in forward transactions is known as forward exchange rate. Forward contract is made for two reasons i.e. to minimize the risk o floss due to adverse changes in the exchange rate through hedging and to make profit through speculation.

• Balance of Payments: Balance of payment refers to the statement of accounts recording all economic transactions of a given country with rest of the world. Each country enters in to economic transactions with other countries of the world.As a result, it receives payments from and makes payments to other countries. BOP is a statement of account of these receipts & payments. It involves inflow & outflow of foreign exchange in a year. It is like a typical business account and is based on double entry system which has two aspects i.e. credit & debit. Any transaction which brings in foreign (i.e. exports) is recorded on credit side whereas any which causes a country to lose foreign exchange (i.e. imports) is recorded on debit side. Similarly, borrowing ROW is a credit item while lending is a debit item.The main purpose of BOP account is to know international economic position of a country & help the government make appropriate trade & payment policies.

• Current Account: The current account of BOP records transactions relating to exchange of goods & services and unilateral transfers.

• Capital Account: It records international transactions which affect assets & liabilities of domestic country with rest of the world.

• Official Reserves: The official reserves of the country may be increased or decreased with a view to finance government expenditure abroad. Reduction in reserves implies purchase of foreign exchange while increase in reserves implies sale of foreign exchange. By changing the reserves, the government is changing its supply / demand status of foreign exchange.This may be done with a view to affect the exchange rate in the international money market.

• Autonomous items: These refer to international economic transactions that take place due to economic motives like profit maximization. They have nothing to do with foreign exchange payments. Since such transactions are independent of the state of country’s BOP i.e. irrespective of whether BOP is favourable or unfavorable, they are, therefore called autonomous items. These items are often called ‘above the lines items’ in BOP.

• Accommodating item: These refer to the transactions that are undertaken in order to maintain the ‘balance’ in BOP account. These items are also known as ‘below the line items’. Accommodating transactions are compensating capital transactions which are meant to correct the disequilibrium in autonomous items of balance of payments. For example: if there is a current account deficit in BOP, then this deficit is settled by capital inflow from abroad. Such a borrowing is an accommodating item because it is undertaken to cover deficit. Other sources to meet deficit are: foreign reserves, borrowings from IMF or foreign monetary authorities.

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