Balance of Payment and foreign exchange

Question 1

International trade

Answer 1

The buying and selling of goods and services and sometimes capital between two or more countries

Question 2

Bilateral trade

Answer 2

Trade between two countries

Question 3

Multilateral trade

Answer 3

Trade among many countries

Question 4

International trade arises because countries differ in their demand for goods and services and in their supply or ability to produce them :

Answer 4

On the demand side:
(i) One country may be able to produce a good in excess quantities than it requires
(ii) While another country may produce less quantities of a good or a service than it requires.
On the supply side:
(i) The production of different goods and services requires different kinds of resources in different proportions.
(ii) Economic resources are unevenly distributed throughout the world.
(iii) Some resources cannot be transferred easily from one country to another e.g. land.
(iv) Barriers of language, custom and restrictions on immigration restrict the international mobility of labor.
(v) Capital is more mobile in the geographical sense but only when favorable conditions exist e.g. political stability, no threats of confiscation, no barriers to taking profits outside the country etc.

Question 5

Balance of payments/ international payments

Answer 5

The record of all economic transactions between the residents of the country and the rest of the world in a particular period of time.
These transactions are made by individuals, firms and government bodies.
Thus the balance of payments includes all external visible and non-visible transactions of a country.

Question 6

Main sections of BOP

Answer 6

Current account

Capital account

Question 7

Components of current account

Answer 7

1. Trade in goods: Exports and imports
2. Trade in services: net factor income (net income from compensation of employees) and net non-factor income (shipping, banking, insurance, tourism, software services etc.)
3. Transfer payments: Consists of gifts, remittances and grants

Question 8

Current Account

Answer 8

• It records income and expenditure flows that result from: trade in goods & services, payment of interest, profit and dividend income on foreign owned assets and international transfers of currency
• It is further split into visible trade and invisible trade.
• All inflows of monies which result from visible and invisible exports are recorded as credit items in the account
• All outflows of monies which result from visible and invisible imports are recorded as debit items in the account.
• A plus item is called a credit, while a negative item is called a debit.
• Because exports provide the country with foreign currency they are called credit items, while imports because they cause the country to use up the stock of foreign currency are debit items.
• The difference between exports and imports is known as a trade balance.
• A positive balance of trade is known as a trade surplus which consists of exporting more than a country is importing.
• A negative balance of trade is known as a trade deficit.
• Thus the excess of imports over exports will give rise to a current account deficit. Excess of exports over imports will give rise to current account surplus.

Question 9

Invisible trade

Answer 9

• Services: shipping, air travel, insurance
• incomes:- it’s the income that flows into the country from non-residents eg interest, profits
• Transfer/current payments

Question 10

Visible trade

Answer 10

• The trade in goods balance- it’s the value of goods exported minus the value of goods imported
• The trade in services balance-it’s the value of services exported minus the value of services imported

Question 11

Factors that can affect the balance of trade

Answer 11

1. Prices of goods produced at home (influenced by the responsiveness of supply).
2. Exchange rates: the exchange rate between currencies specifies how much one currency is worth in terms of the other.
3. Trade agreements or barriers and trade measures
4. The tariffs and trade laws of a political region state or trade blocs determine which forms of consumption and production tend to be encouraged or discouraged.

Question 12

Capital account

Answer 12

• It records long-term and short-term capital movements between countries.
• These are loans private citizens or governments make to or receive from foreign private citizens or governments.
• When a country borrows it receives foreign currencies hence this is recorded as credit item(+), while lending results in outflow of funds hence is recorded as a debit item (-).
• The long term capital movements include direct investments , portfolio investments (which involves purchasing of securities of a foreign company or government) and inter-government loans.
• The short-term capital movements include all forms of short term private lending and short-term investments.
• The capital account also includes those transactions which are necessary to cover any overall deficits or surpluses in the rest of the accounts sometimes put in a separate account called official financing.
• These transactions include changes in the official reserves of foreign currency and foreign currency borrowing and lending.
• The official financing items represent transactions involving the central bank of the country whose balance of payments is being recorded.
• There are three ways in which credit items may occur on the official financing account.
  1. The central bank may borrow from the IMF. This represents a capital inflow.
  2. The central bank may borrow from other central banks.
  3. The central bank may run down its official reserves of gold and foreign exchange.

Question 13

Overall BOP

Answer 13

• The difference between receipts and payments on both current and capital accounts is called the overall balance of payments.
• A favorable BOP exists when the receipts on both current and capital accounts exceeds the payments. In this case there is said to exist a surplus.
• Unfavorable BOP exists when payments on both current and capital accounts exceeds receipts. In this case there is a said to exist a deficit.
• In this case a country with fixed exchange rate will be losing its reserves of foreign currency and getting into more debts with international communities.

Question 14

Causes of B. O. P Disequilibrium in Developing Countries

Answer 14

1. Variations in trade. Most developing countries export agricultural products in the world market while they import manufactured products.
2. Technological changes. This has brought in new methods of production which saves on the use of agricultural raw materials . This has drastically reduced the demand for agricultural raw materials.
3. Stage of economic development. Most developing countries are in their early stages of economic development.
4. Inflation. If the rate of inflation in the domestic country is higher than the rates in major trading partners, then the prices in the domestic country will become less competitive compared to imports.
5. Progressive liberalization of world trade which often favor developed countries at the expense of developing countries

Question 15

Solutions to B. O. P Problems

Answer 15

a) Imposition of direct controls on imports: The government through its central bank can undertake to borrow domestically from commercial banks and other financial institutions.
(b) Export promotion: A country can use several methods to do this.
(c) Borrow from International Monetary Fund (I. M. F). Along with this the country can also get aids and grants.
(d) Use of the country’s foreign reserves in the central bank. This is however, a short-term solution as it involves the transfer of money.
(d) Devaluation. This refers to a deliberate attempt by the government to lower the value of the domestic currency in relation to other countries’ currencies. Devaluation tends to make a country’s export cheaper in the international market while it makes imports relatively more expensive.

Question 16

Conditions for devaluation to succeed

Answer 16

• The demand for and supply of exports must be price elastic both.
• Demand for imports should exhibit a very high price elasticity.
• Other trading partners should not also devalue their currencies in retaliation or impose other quantitative trade restrictions.
• Devaluation should not be accompanies by serious inflationary effects.

Question 17

Foreign exchange

Answer 17

• The foreign exchange market is an organizational setting within which individuals, business firms, banks etc. buy and sell foreign currency.
• It has no centralized meeting place and not limited to one country.
• The exchange rate is the amount of foreign currency that may be bought for one unit of domestic currency.
  It is simply the price at which one currency can be traded for another.

Question 18

Exchange rates regime: Fixed and Flexible

Answer 18

Fixed Exchange Rate Regime

• In a fixed exchange rate regime, the external value country’s currency is determined by explicit government policy and fixed at a certain amount of the domestic currency per unit of foreign currency.
• Periodic changes in the exchange rate by government are described as devaluation or revaluation
• Devaluation refers to the deliberate reduction in the external value of a domestic currency.
• On the other hand, revaluation is a deliberate increase in the value of a country’s currency relative to other currencies.

Question 19

Advantages & Disadvantages of fixed exchange rate

Answer 19

• Advantages:
  (i) It removes the uncertainty associated with the flexible exchange rate regime and brings stability.
  (ii) It also indirectly imposes some anti inflationary discipline on policy makers since there is need to maintain and defend the exchange rate.
• Disadvantages:
  (i) The currency may stay overvalued or under valued
  (ii) May create a parallel foreign exchange market referred to as black market

Question 20

Flexible Exchange Rate Regime

Answer 20

• The external value of a country’s currency is determined by the forces of demand and supply.
• The exchange rate for the country is the result of the interaction between demand and supply of foreign currency.
• Many Countries of the world in recent times have adopted flexible exchange rate with some modifications.
• In a flexible exchange rate regime variations in the exchange rate are referred to as depreciation or appreciation.
• Appreciation means the value of a country’s domestic currency has increased relative to foreign currencies.
• Depreciation refers to a fall in the value of a country’s domestic currency relative to foreign currencies.
• The value of country’s currency changes frequently even by the minute.
• The market rate will depend on the demand for and supply of that currency in the forex market. (exchange rate determination)

Question 21

Advantages & Disadvantages of flexible exchange rate

Answer 21

• Advantages:
  1. Automatic stabilization of the balance of payments: Under this regime any balance of payments disequilibrium is rectified by a change in the exchange rate
  2. It prevents overvaluation and undervaluation of the domestic currency since its external value is determined by demand and supply.
• Disadvantages:
  1. Some degree of uncertainty may be introduced into the economy since the value the currency changes from day-to-day.
  2. It may also lead to speculation in the foreign exchange markets due to the day-to-day changes in the currency’s value

Question 22

Changes in exchange rate

Answer 22

• An appreciation in the exchange rate could be caused by either:-
  an increase in demand for exports
  a decrease in demand for imports
• A depreciation is the rate of exchange could be caused by;
  An increased demand for imports;
  A decreased foreign demand for exports

Question 23

Other factors affecting exchange rate

Answer 23

InflationRates. 
InterestRates. 
Country's Current Account / Balance of Payments
Government Debt
Terms of Trade
Political Stability & Performance.
Recession
Speculation