BCM109_Macro Economics(Draft 2)

Measures to reduce fiscal deficit: (a) Measures to reduce public expenditure are: (i) A drastic reduction in expenditure on major subsidies. (ii) Reduction in expenditure on bonus, LTC, leaves encashment, etc. (iii)Austerity steps to curtail non-plan expenditure. (b) Measures to increase revenue are: (i) Tax base should be broadened and concessions and reduction in taxes should be curtailed. (ii) Tax evasion should be effectively checked. (iii)More emphasis on direct taxes to increase revenue. (iv)Restructuring and sale of shares in public sector units. 11.5.3 Primary Deficit: Primary deficit is defined as fiscal deficit of current year minus interest payments on previous borrowings. In other words whereas fiscal deficit indicates borrowing requirement inclusive of interest payment, primary deficit indicates borrowing requirement exclusive of interest payment (i.e., amount of loan). We have seen that borrowing requirement of the government includes not only accumulated debt, but also interest payment on debt. If we deduct ‘interest payment on debt’ from borrowing, the balance is called primary deficit. It shows how much government borrowing is going to meet expenses other than Interest payments. Thus, zero primary deficits means that government has to resort to borrowing only to make interest payments. To know the amount of borrowing on account of current expenditure over revenue, we need to calculate primary deficit. Thus, primary deficit is equal to fiscal deficit less interest payments. Symbolically: Primary deficit = Fiscal deficit – Interest payments For instance, primary deficit in Government budget estimates for the year 2012-13 amounted to Rs 1,93,831 crore (= Fiscal deficit 5,13,590 – interest payment 3,19,759) vide budget summary in section 9.18. Importance: 201 CU IDOL SELF LEARNING MATERIAL (SLM)

Fiscal deficit reflects the borrowing requirements of the government for financing the expenditure inclusive of interest payments. As against it, primary deficit shows the borrowing requirements of the government including interest payment for meeting expenditure. Thus, if primary deficit is zero, then fiscal deficit is equal to interest payment. Then it is not adding to the existing loan. Thus, primary deficit is a narrower concept and a part of fiscal deficit because the latter also includes interest payment. It is generally used as a basic measure of fiscal irresponsibility. The difference between fiscal deficit and primary deficit reflects the amount of interest payments on public debt incurred in the past. Thus, a lower or zero primary deficits means that while its interest commitments on earlier loans have forced the government to borrow, it has realized the need to tighten its belt. 11.6 FISCAL POLICY AND ITS TYPES Fiscal policy is how Congress and other elected officials influence the economy using spending and taxation. It is used in conjunction with the monetary policy implemented by central banks, and it influences the economy using the money supply and interest rates. The objective of fiscal policy is to create healthy economic growth. Ideally, the economy should grow between 2%–3% a year, unemployment will be at its natural rate of 3.5%–4.5%, and inflation will be at its target rate of 2%. The business cycle will be in the expansion phase. 11.6.1 Expansionary Fiscal Policy There are two types of fiscal policy. The most widely-used is expansionary, which stimulates economic growth. Congress uses it to end the contraction phase of the business cycle when voters are clamoring for relief from a recession. The government either spends more, cuts taxes, or both. The idea is to put more money into consumers' hands, so they spend more. The increased demand forces businesses to add jobs to increase supply. Politicians debate about which works better. Advocates of supply-side economics prefer tax cuts because they say it frees up businesses to hire more workers to pursue business ventures. Advocates of demand-side economics say additional spending is more effective than tax cuts. Examples include public works projects, unemployment benefits, and food stamps. The money goes into the pockets of consumers, who go right out and buy the things businesses produce. An expansionary fiscal policy is impossible for state and local governments because they are mandated to keep a balanced budget. If they haven't created a surplus during the boom times, 202 CU IDOL SELF LEARNING MATERIAL (SLM)

they must cut spending to match lower tax revenue during a recession. That makes the contraction worse. Fortunately, the federal government has no such constraints; it's free to use expansionary policy whenever it's needed. Unfortunately, it also means Congress created budget deficits even during economic booms—despite a national debt ceiling. As a result, the critical debt-to-gross domestic product ratio has exceeded 100%. 11.6.2 Contractionary Fiscal Policy The second type of fiscal policy is contractionary fiscal policy, which is rarely used. Its goal is to slow economic growth and stamp out inflation. The long-term impact of inflation can damage the standard of living as much as a recession. The tools of contractionary fiscal policy are used in reverse. Taxes are increased, and spending is cut. You can imagine how wildly unpopular this is among voters. Only lame duck politicians could afford to implement contractionary policy. Tools The first tool is taxation. That includes income, capital gains from investments, property, and sales. Taxes provide the income that funds the government. The downside of taxes is that whatever or whoever is taxed has less income to spend on themselves, which is why taxes are unpopular. The second tool is government spending—which includes subsidies, welfare programs, public works projects, and government salaries. Whoever receives the funds has more money to spend, which increases demand and economic growth. The federal government is losing its ability to use discretionary fiscal policy because each year more of the budget must go to mandated programs. As the population ages, the costs of Medicare, Medicaid, and Social Security are rising. Changing the mandatory budget requires an Act of Congress, and that takes a long time. One exception was the American Recovery and Reinvestment Act. Congress passed it quickly to stop the Great Recession 11.7 SUMMARY  Government budget, forecast by a government of its expenditures and revenues for a specific period of time. In national finance, the period covered by a budget is usually a year, known as a financial or fiscal year, which may or may not correspond with the calendar year. The word budget is derived from the Old French bougette (“little bag”). When the British Chancellor of the Exchequer makes his annual financial statement, he is said to “open” his budget, or receptacle of documents and accounts.  Government Budget is the financial statement that shows item-wise estimate of the 203 CU IDOL SELF LEARNING MATERIAL (SLM)

expected revenue and anticipated expenditure during a fiscal year. A budget is needed to know the financial performance of the government over the past one year and to know the financial programs and policies of the government for the next one year. There are many objectives of the government budget, such as allocation of resources, public accountability, etc.  There are mainly two types of budget in India: Union and State budget. The union budget is the prepared by the central government and is presented in the Lok Sabha; it is divided into the railway budget and main budget. State budget is prepared by the state government and presented before the state legislative assembly.  Government budget is classified into revenue budget and capital budget, which are further classified into revenue receipts and revenue expenditure and capital receipts and capital expenditure.  Revenue receipts are further classified into: Tax Revenue and Non-Tax Revenue. Tax Revenue: It is divided into direct tax and indirect tax. Non-Tax Revenue: is classified into commercial revenues and administrative revenue.  Capital Receipts create a liability or lead to a reduction in assets. These are: Recovery of loans and advances, External assistance, etc.  Budget expenditure of the government is classified under three broad heads as: Revenue and capital expenditure, Plan and non-plan expenditure and Development and non-development expenditure.  Revenue Expenditure: These are expenditure that neither creates any assets nor reduce any liability of government. For example, expenditure by the government on old age pension, etc.  Capital Expenditure: These are the expenditure that either creates asset or causes reduction in liabilities. For example: repayment of the loan.  Balanced Budget shows that the government’s estimated receipts are equal to its estimated expenditure. Unbalanced Budget shows that the government’s estimated receipts are not equal to its estimated expenditure.  Unbalance balanced budget is of two types: Budget Surplus and Budget Deficit. There are three types of budget deficit; Revenue Deficit (excess of revenue expenditure over revenue receipts), Fiscal Deficit (reflects the borrowing requirements of the government) and Primary Deficit (difference between fiscal deficit and interest payment). 204 CU IDOL SELF LEARNING MATERIAL (SLM)

11.8 KEY WORDS/ABBREVIATIONS  Government Budget: A government budget is an annual financial statement showing item wise estimates of expected revenue and anticipated expenditure during a fiscal year.  Balanced Budget: If the government revenue is just equal to the government expenditure made by the general government, then it is known as balanced budget.  Unbalanced budget: If the government expenditure is either more or less than a government receipts, the budget is known as unbalanced budget.  Budget receipt: It refers to the estimated receipts of the government from various sources during a fiscal year.  Budget expenditure: It refers to the estimated expenditure of the government on its “development and non-development programmes or “plan and non-plan programmes during the fiscal year 11.9 LEARNING ACTIVITY 1. Note on objectives of government budget __________________________________________________________________________________ __________________________________________________________________________________ 2. Explain the components of government budget __________________________________________________________________________________ __________________________________________________________________________________ 11.10 UNIT END EXERCISES (MCQS AND DESCRIPTIVE) A. Descriptive Questions 1. State the classification of receipts 2. Explain the measures of government deficits 3. State the classification of expenditures 4. Note on fiscal policy 5. What are the different types of fiscal policy B. Multiple Choice Questions (MCQs) 1. The government budget is an 205 CU IDOL SELF LEARNING MATERIAL (SLM)

(a) Half yearly statement 206 (b) Weekly statement (c) Five yearly statement (d) Annual statement 2. The government budget shows the government’s (a) Actual receipts and expenditure (b) Estimated receipts only (c) Estimated expenditure only (d) Estimated receipts and expenditure 3. The major source of Revenue receipts for the government is (a) Interest (b) Tax Revenue (c) Profits (d) Non Tax Revenue 4. _______ is the difference between total receipts and total expenditure: (a) Fiscal Deficit (b) Budget Deficit (c) Revenue Deficit (d) Capital Deficit 5. If borrowing and other liabilities are added to the budget deficits we get ____: (a) Fiscal Deficit (b) Primary Deficit (c) Capital Deficit (d) Revenue Deficit CU IDOL SELF LEARNING MATERIAL (SLM)

Answers: 1. (d) 2. (d) 3. (b) 4. (b) 5. (a) 11.11 REFERENCES  Dwivedi, D.N. (2006). Macroeconomics: Theory and Policy. New Delhi: Tata McGraw Hill.  Ray, N.C. (1980). An introduction to Macro Economics. New Delhi: The Macmillan Company of India.  Lipsey, R.G. & Chrystal, K.A. (2004). Economics. New Delhi: Oxford University Press.  Shapiro, Edward. (2009). Macroeconomic Analysis. New York: Harcourt Publishers Ltd.  Peterson, L., Jain. (2005). Managerial Economic. New Delhi: Prentice Hall of India.  Mote, V.L., Gupta G.S. (2017). Managerial Economics. New Delhi: McGraw Hill Education. 207 CU IDOL SELF LEARNING MATERIAL (SLM)

208 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 12- BALANCE OF PAYMENTS Structure 12.0. Learning Objectives 12.1. Introduction 12.2. Balance of payments account - meaning and components 12.2.1 Components 12.3. Balance of payments deficit- meaning 12.4. Current and Capital account 12.4.1 Current account 12.4.2 Capital account 12.5. Foreign exchange rate - meaning of fixed and flexible rates and managed floating 12.6. Determination of exchange rate in a free market 12.6.1 Demand for Foreign Exchange (US Dollars) 12.6.2 Supply of Foreign Exchange (US Dollars) 12.6.3 The Equilibrium Exchange Rate 12.7. Managed or Dirty Floating 12.8. Summary 12.9. Key Words/Abbreviations 12.10. Learning Activity 12.11. Unit End Exercises (MCQs and Descriptive) 12.12. References 12.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  List the details of the concept of balance of payment & balance of trade  Explain the terms related to Forex market 209 CU IDOL SELF LEARNING MATERIAL (SLM)

12.1 INTRODUCTION Balance of Payment (BOP) is a statement which records all the monetary transactions made between residents of a country and the rest of the world during any given period. This statement includes all the transactions made by/to individuals, corporates and the government and helps in monitoring the flow of funds to develop the economy. When all the elements are correctly included in the BOP, it should sum up to zero in a perfect scenario. This means the inflows and outflows of funds should balance out. However, this does not ideally happen in most cases. BOP statement of a country indicates whether the country has a surplus or a deficit of funds i.e. when a country’s export is more than its import, its BOP is said to be in surplus. On the other hand, BOP deficit indicates that a country’s imports are more than its exports. Tracking the transactions under BOP is something similar to the double entry system of accounting. This means, all the transaction will have a debit entry and a corresponding credit entry. 12.2 BALANCE OF PAYMENTS ACCOUNT - MEANING AND COMPONENTS The balance of payments (henceforth BOP) is a consolidated account of the receipts and pay-ments from and to other countries arising out of all economic transactions during the course of a year. In the words of C. B. Kindle Berger; “The balance of payments of a country is a sys­tematic record of all economic transactions between the residents of the reporting and the residents of the foreign countries during a given period of time.” Here, by ‘residents’ we mean individuals, firms and government. By all economic transactions we mean transac-tions of both visible goods (merchandise) and invisible goods (services), assets, gifts, etc. In other words, BOP shows how money is spent abroad (i.e. payments) and how money is received domestically (i.e., receipts). Thus, a BOP account records all payments and re-ceipts arising out of all economic transactions. 12.21 Components 210 CU IDOL SELF LEARNING MATERIAL (SLM)

Fig. 12.1 Balance of payments account 12.3 BALANCE OF PAYMENTS DEFICIT- MEANING A balance of payments deficit means the nation imports more commodities, capital and services than it exports. It must take from other nations to pay for their imports. The nation could use its reserves of foreign exchange in order to balance any shortfall in its BoP:  When the foreign exchange is being sold by the reserve bank when there is a deficit, it is known as official reserve sale.  The decrease or increase in official reserves is known as the overall balance of payments deficit or surplus.  The fundamental hypothesis is that the monetary authorities are the final financiers of any deficit in the BoP (or the recipients of any surplus.  Official reserve transactions are relevant under the reign of the fixed exchange rates than when exchange rates are floating. 12.4 CURRENT AND CAPITAL ACCOUNT Components of Balance of Payments: (1) Current Account; (2) Capital Account! 12.4.1 Current Account: Current account refers to an account which records all the transactions relating to export and 211 CU IDOL SELF LEARNING MATERIAL (SLM)

import of goods and services and unilateral transfers during a given period of time. Current account contains the receipts and payments relating to all the transactions of visible items, invisible items and unilateral transfers. Components of Current Account: The main components of Current Account are: 1. Export and Import of Goods (Merchandise Transactions or Visible Trade): A major part of transactions in foreign trade is in the form of export and import of goods (visible items). Payment for import of goods is written on the negative side (debit items) and receipt from exports is shown on the positive side (credit items). Balance of these visible exports and imports is known as balance of trade (or trade balance). 2. Export and Import of Services (Invisible Trade): It includes a large variety of non- factor services (known as invisible items) sold and purchased by the residents of a country, to and from the rest of the world. Payments are either received or made to the other countries for use of these services. Services are generally of three kinds: (a) Shipping, (b) Banking, and (c) Insurance. Payments for these services are recorded on the negative side and receipts on the positive side. 3. Unilateral or Unrequited Transfers to and from abroad (One sided Transactions): Unilateral transfers include gifts, donations, personal remittances and other ‘one-way’ transactions. These refer to those receipts and payments, which take place without any service in return. Receipt of unilateral transfers from rest of the world is shown on the credit side and unilateral transfers to rest of the world on the debit side. 4. Income receipts and payments to and from abroad: It includes investment income in the form of interest, rent and profits. Current Account shows the Net Income: Current Account records all the actual transactions of goods and services which affect the income, output and employment of a country. So, it shows the net income generated in the 212 CU IDOL SELF LEARNING MATERIAL (SLM)

foreign sector. Balance on Current Account: In the current account, receipts from export of goods, services and unilateral receipts are entered as credit or positive items and payments for import of goods, services and unilateral payments are entered as debit or negative items. The net value of credit and debit balances is the balance on current account. 1. Surplus in current account arises when credit items are more than debit items. It indicates net inflow of foreign exchange. 2. Deficit in current account arises when debit items are more than credit items. It indicates net outflow of foreign exchange. Components of Current Account: Credit Items Debit Items Net Credit (Credit – Debit) Visible Trade Imports of goods Net Exports of goods Exports of goods (Balance of Trade) Invisible Trade Imports of services Net Exports of Exports of services services Unilateral Transfer Payments Net Transfer Receipts Transfers Transfer Receipts Income Receipts Income Payments Net Income Receipts & Payments Income Receipts Current Receipts Current Payments Current Account (1+2+3+4) Balance Table 12.2 Components of Current Account: 12.4.2 Capital Account: Capital account of BOP records all those transactions, between the residents of a country and 213 CU IDOL SELF LEARNING MATERIAL (SLM)

the rest of the world, which cause a change in the assets or liabilities of the residents of the country or its government. It is related to claims and liabilities of financial nature. Capital Account is used to: (i) Finance deficit in current account; or (ii) Absorb surplus of current account. Capital account is concerned with financial transfers. So, it does not have direct effect on income, output and employment of the country. Components of Capital Account: The main components of capital account are: 1. Borrowings and landings to and from abroad: It includes: A. All transactions relating to borrowings from abroad by private sector, government, etc. Receipts of such loans and repayment of loans by foreigners are recorded on the positive (credit) side. B. All transactions of lending to abroad by private sector and government. Lending abroad and repayment of loans to abroad is recorded as negative or debit item. 2. Investments to and from abroad: It includes: A. Investments by rest of the world in shares of Indian companies, real estate in India, etc. Such investments from abroad are recorded on the positive (credit) side as they bring in foreign exchange. B. Investments by Indian residents in shares of foreign companies, real estate abroad, etc. Such investments to abroad be recorded on the negative (debit) side as they lead to outflow of foreign exchange. 3. Change in Foreign Exchange Reserves: The foreign exchange reserves are the financial assets of the government held in the central bank. A change in reserves serves as the financing item in India’s BOP. So, any withdrawal from the reserves is recorded on the positive (credit) side and any addition to these reserves is recorded on the negative (debit) side. It must be noted that ‘change in reserves’ is recorded in the BOP account and not ‘reserves’. Balance on Capital Account: The transactions, which lead to inflow of foreign exchange (like receipt of loan from abroad, 214 CU IDOL SELF LEARNING MATERIAL (SLM)

sale of assets or shares in foreign countries, etc.), are recorded on the credit or positive side of capital account. Similarly, transactions, which lead to outflow of foreign exchange (like repayment of loans, purchase of assets or shares in foreign countries, etc.), are recorded on the debit or negative side. The net value of credit and debit balances is the balance on capital account. A. Surplus in capital account arises when credit items are more than debit items. It indicates net inflow of capital. B. Deficit in capital account arises when debit items are more than credit items. It indicates net outflow of capital. In addition to current account and capital account, there is one more element in BOP, known as ‘Errors and Omissions’. It is the balancing item, which reflects the inability to record all international transactions accurately. Credit Items Debit Items Net Credit (Credit – Debit) Borrowings and Landings to abroad Net Borrowings lending’s to and from abroad from abroad Borrowings from abroad Investments from Investments to Net Investments abroad Investments abroad from abroad from abroad Increases in foreign Net change in Change in Foreign exchange reserves foreign exchange Exchange Reserves reserves Decreases in foreign exchange reserves Capital Receipts Capital Payments Capital Account (1+2+3): Balance Table 12.3 Capital Account: 215 CU IDOL SELF LEARNING MATERIAL (SLM)

Balance on Current Account Vs. Balance on Capital Account: Balance on current account and balance on capital account are interrelated. A. A deficit in the current account must be settled by a surplus on the capital account. B. A surplus in the current account must be matched by a deficit on the capital account. 12.5 FOREIGN EXCHANGE RATE - MEANING OF FIXED AND FLEXIBLE RATES AND MANAGED FLOATING There may be variety of exchange rate systems (types) in the foreign exchange market. Its two broad types or systems are Fixed Exchange Rate and Flexible Exchange Rate as explained below. In between these two extreme rates, there are some hybrid systems like Crawling Peg, Managed Floating. Broadly when government decides the conversion rate, it is called fixed exchange rate. On the other hand, when market forces determine the rate, it is called floating exchange rate. (a) Fixed Exchange Rate System: Fixed exchange rate is the rate which is officially fixed by the government or monetary authority and not determined by market forces. Only a very small deviation from this fixed value is possible. In this system, foreign central banks stand ready to buy and sell their currencies at a fixed price. A typical kind of this system was used under Gold Standard System in which each country committed itself to convert freely its currency into gold at a fixed price. In other words, value of each currency was defined in terms of gold and, therefore, exchange rate was fixed according to the gold value of currencies that have to be exchanged. This was called mint par value of exchange. Later on Fixed Exchange Rate System prevailed in the world under an agreement reached in July 1994. The advantages and disadvantages of this system are as under: Merits: (i) It ensures stability in exchange rate which encourages foreign trade, (ii) It contributes to the coordination of macro policies of countries in an interdependent world economy, (iii) Fixed exchange rate ensures that major economic disturbances in the member countries do not occur, (iv) It prevents capital outflow, (v) Fixed exchange rates are more conducive to expansion of world trade because it prevents risk and uncertainty in transactions, (vi) It 216 CU IDOL SELF LEARNING MATERIAL (SLM)

prevents speculation in foreign exchange market. Demerits: (i) Fear of devaluation. In a situation of excess demand, central bank uses its reserves to maintain foreign exchange rate. But when reserves are exhausted and excess demand still persists, government is compelled to devalue domestic currency. If speculators believe that exchange rate cannot be held for long, they buy foreign exchange in massive amount causing deficit in balance of payment. This may lead to larger devaluation. This is the main flaw or demerit of fixed exchange rate system, (ii) Benefits of free markets are deprived; (iii) There is always possibility of under-valuation or over-valuation. (b) Flexible (Floating) Exchange Rate System: The system of exchange rate in which rate of exchange is determined by forces of demand and supply of foreign exchange market is called Flexible Exchange Rate System. 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. Under this system, the central bank, without intervention, allows the exchange rate to adjust so as to equate the supply and demand for foreign currency In India, it is flexible exchange rate which is being determined. The foreign exchange market is busy at all times by changes in the exchange rate. Advantages and disadvantages of this system are listed below: Merits: (i) Deficit or surplus in BOP is automatically corrected, (ii) There is no need for government to hold any foreign exchange reserve, (iii) It helps in optimum resource allocation, (iv) It frees the government from problem of BOP Demerits: (i) It encourages speculation leading to fluctuations in foreign exchange rate, (ii) Wide fluctuation in exchange rate hampers foreign trade and capital movement between countries, (iii) It generates inflationary pressure when prices of imports go up due to depreciation of currency. (c) Distinction between Fixed Exchange Rate and Flexible Exchange Rate [AOS; D09]: Fixed exchange rate is the rate which is officially fixed in terms of gold or any other currency by the government. It does not change with change in demand and supply of foreign currency. As against it, flexible exchange rate is the rate which, like price of a commodity, is determined by forces of demand and supply in the foreign exchange market. It changes 217 CU IDOL SELF LEARNING MATERIAL (SLM)

according to change in demand and supply of foreign currency. There is no government intervention. 12.6 DETERMINATION OF EXCHANGE RATE IN A FREE MARKET How in a flexible exchange system the exchange of a currency is determined by demand for and supply of foreign exchange. We assume that there are two coun-tries, India and USA, the exchange rate of their currencies (namely, rupee and dollar) is to be deter-mined. Thus, we explain below how the value of a dollar in terms of rupees (which will conversely indicate the value of a rupee in terms of dollars) is determined. At present in both USA and India there is floating or flexible exchange regime. Therefore, the value of currency of each country in terms of the other depends upon the demand for and supply of their currencies. It is in the foreign exchange market that the exchange rate among different currencies is deter-mined. The foreign exchange market is the market in which the currencies of various countries are converted into each other or exchanged for each other. In our case of the determination of exchange rate between US dollar and Indian rupee, the Indians sell rupees to buy US dollars (which is a foreign currency) and the Americans or others holding US dollars will sell dollars in exchange for rupees. It is the demand for and supply of a foreign currency or exchange that will determine the exchange rate between the two. 12.6.1 Demand for Foreign Exchange (US Dollars): The demand for US dollars comes from the Indian people and firms who need US dollars to pay for the goods and services they want to import from the USA. The greater the imports of goods and services from the USA, the greater the demand for the US dollars by the Indians. Further, the demand for dollars also arises from Indian individuals and firms wanting to purchase assets in the USA, that is, desire to invest in US bonds and equity shares of the American companies or build factories, sales facilities or houses in the USA. The demand for dollars also arises from those who want to give loans or send gifts to some people in the USA. Thus, for whatever reasons the Indian residents need dollars they have to buy them in the foreign ex-change market and pay for them with the Indian currency, the rupees. All of these constitute de-mand for dollars, the foreign exchange. To sum up, the demand for dollars by the Indians arises due to the following factors: 1. The Indian individuals, firms or Govern-ment who import goods from the USA into India. 218 CU IDOL SELF LEARNING MATERIAL (SLM)

2. The Indians travelling and studying in the USA would require dollars to meet their trav-elling and education expenses. 3. The Indians who want to invest in equity shares and bonds of the US companies and other financial instruments. 4. The Indian firms who want to invest directly in building factories, sales facilities, shops in the USA. An important thing to understand is how the demand curve for a foreign exchange would look like. When there is a fall in the price of dollar in terms of rupees, that is, when the dollar depreci-ates, fewer rupees than before would be required to get a dollar. With this, therefore, a dollar’s worth of US goods could be purchased with fewer rupees, that is, the US goods would become cheaper in terms of rupees for Indians. This will induce the Indian individuals and firms to import more from the USA resulting in the increase in quantity demanded of dollars by the Indians. On the other hand, if the price of US dollar rises, (that is US dollar appreciates) a dollar’s worth of US goods would now cost more in terms of rupees making American goods relatively expensive than before. This will discourage the imports of US goods to India causing a decrease in quantity de-manded of dollars for imports. It therefore follows from above that at a lower price of dollars, the greater quantity of dollars is demanded for imports from the USA and at a higher price of dollar, the smaller quantity of dollars is demanded for imports from the USA by the Indians. This makes the demand curve for dollars downward sloping as shown by the DD curve in Fig. 12.4. Fig. 12.4 Demand for Foreign Exchange (US Dollars): 219 12.6.2 Supply of US Dollars (i.e., Foreign Exchange): CU IDOL SELF LEARNING MATERIAL (SLM)

What determines the supply of dollars in the foreign exchange market? The individual firms and Government which export Indian goods to the USA will earn dollars from the American residents who would buy the Indian goods imported into the USA and pay their price in dollars. Further, the Americans who travel in India and use the services of Indian transport, hotels etc., will also supply dollars to be converted into rupees for meeting these expenses. Besides, the American firms and individuals who want to buy assets in India, such as bonds and equity shares of Indian companies or wish to make loans to the Indian individuals and firms will also supply dollars. There are Indians who are working in the USA and send their earnings in dollars to their relatives and friends. The supply of these dollars by the Indians working in the USA popularly called remittances from the USA also adds to the supply of dollars. Those holding dollars who have earned them from exports to the USA and the foreign firms and individuals who want to invest in India or those who want to make loans to Indians or the American tourists travelling in India, and remittances from USA by the Indians working there will supply dollars in the foreign exchange market. 12.7 MANAGED OR DIRTY FLOATING This refers to a system of gradual adjustments in the exchange rate deliberately made by a central bank to influence the value of its own currency in relation to other currencies. This is done to save its own currency from short-term volatility in exchange rate caused by economic shocks and speculation. Thus, central bank intervenes to smoothen out ups and downs in the exchange rate of home currency to its own advantage. When central bank manipulates floating exchange rate to disadvantage of other countries, it is termed as dirty floating. However, central banks have no fixed times for intervention but have a set of rules and guidelines for this purpose. 12.8 SUMMARY A country’s BOP is vital for the following reasons:  BOP of a country reveals its financial and economic status.  BOP statement can be used as an indicator to determine whether the country’s currency value is appreciating or depreciating.  BOP statement helps the Government to decide on fiscal and trade policies.  It provides important information to analyze and understand the economic dealings of a country 220 CU IDOL SELF LEARNING MATERIAL (SLM)

with other countries. By studying its BOP statement and its components closely, 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.  The balance of payments keeps track of all the transactions between a countries and the rest of the world during a year.  In the BoP, sales of goods and services are credits and purchases are debits. Therefore exports are credits (+) and imports are debits (-).  Financial account sales are increases in foreign-owned assets in the US (i.e. sales of U.S. assets to the rest of the world resulting in financial inflows). By analogy to current account sales (exports thus credit), increases in foreign-owned assets in the US are credit (+) entries.  Financial account purchases are increase in U.S.-owned assets abroad (i.e. U.S. purchases of foreign assets resulting in financial outflows). By analogy to current account purchases (imports thus debit), increases in US-owned assets abroad are debit (-) entries.  In the balance of payments, the financial accounts refer to financial flows (in or out) overtime, i.e. to change in stocks of assets. At the end of the year the new level of the stocks of assets owned by the US overseas and the stocks of assets owned by foreigners in the US are recorded in a table entitled the international investment position of the US.  The exchange rate is the relative price of two currencies; it can always be quoted by one number or by its inverse.  The standard approach is to quote exchange rate from the point of view of the domestic economy as the price of one unit of foreign currency.  When we mention appreciation or depreciation, we must always specify the currencies involved, since the appreciation of one currency must necessarily correspond to the depreciation of the other currency.  In the short run with fixed prices, nominal and real exchanges rates are equivalent.  With bilateral exchange rates, a depreciation of the domestic is an increase in the exchange rate (more units of domestic currency needed to buy one unit of foreign currency. With multilateral exchange rates, a depreciation is a decrease in the index 221 CU IDOL SELF LEARNING MATERIAL (SLM)

measuring the overall exchange rate of the domestic currency with respect to a bunch of other currencies.  The foreign exchange market is like any other market insofar as something is being bought and sold. However, the foreign exchange market is unique in two ways:  A currency is being bought and sold, rather than a good or service  The currency being bought and sold is being bought with a different currency. 12.9 KEY WORDS/ABBREVIATIONS  Foreign exchange: refers to all the currencies of the rest of the world other than the domestic currency of the country. For example, in India, US dollar is the foreign exchange.  Foreign Exchange Rate: The rate at which one currency is exchanged for another is called Foreign Exchange Rate. In other words, the foreign exchange rate is the price of one currency stated in terms of another currency. For example, if one U.S dollar exchanges for 60 Indian rupees, then the rate of exchange is 1$ = Rs. 60 or 1 Rs = 1/60 or 0.0166 U.S. dollar.  Foreign exchange market: is the market where the national currencies are converted, exchanged or traded for one another. 12.10 LEARNING ACTIVITY 1. The balance of trade shows a deficit of Rs. 300 crores. The value of exports is Rs. 500 crores. What is the value of imports? __________________________________________________________________________________ __________________________________________________________________________________ 2. Does a BOP always balance? Explain __________________________________________________________________________________ __________________________________________________________________________________ 12.11 UNIT END EXERCISES (MCQS AND DESCRIPTIVE) A. Descriptive Questions 1. Explain Current Account 222 CU IDOL SELF LEARNING MATERIAL (SLM)

2. Explain Capital Account 223 3. Explain Fixed & Floating Rate 4. Note on Forex Rate 5. What are the determinants of exchange rate in a free market B. Multiple Choice Questions (MCQs) 1. Balance of payments of a country includes: (a) Current account (b) Monetary account (c) Capital account (d) All of these 2. Balance of payments of a country has parts: (a) 2 (b) 3 (c) 4 (d) 5 3. Exchange rate for currencies is determined by supply and demand in system of: (a) Fixed exchange rate (b) Flexible (c) Constant (d) Govt. regulated 4. Invisible items in balance of payments include: (a) Foreign remittances (b) Income from tourists (c) Internet charges CU IDOL SELF LEARNING MATERIAL (SLM)

(d) All the three 5. __________ is the rate which is officially fixed by the government or monetary authority and not determined by market forces. (a) Fixed Exchange Rate (b) Flexible Exchange Rate (c) Managed Exchange Rate (d) Dirty Exchange Rate Answers: 1. (d) 2. (b) 3. (b) 4. (d) 5. (a) 12.12 REFERENCES  Dwivedi, D.N. (2006). Macroeconomics: Theory and Policy. New Delhi: Tata McGraw Hill.  Ray, N.C. (1980). An introduction to Macro Economics. New Delhi: The Macmillan Company of India.  Lipsey, R.G. & Chrystal, K.A. (2004). Economics. New Delhi: Oxford University Press.  Shapiro, Edward. (2009). Macroeconomic Analysis. New York: Harcourt Publishers Ltd.  Peterson, L., Jain. (2005). Managerial Economic. New Delhi: Prentice Hall of India.  Mote, V.L., Gupta G.S. (2017). Managerial Economics. New Delhi: McGraw Hill Education. 224 CU IDOL SELF LEARNING MATERIAL (SLM)