In simple words, Balance of Payments is a record of all the transactions between two economies in a period like a year or so. Now let us look into how an economy can do transactions with the rest of the world.
There are two main accounts in Balance of Payments, one is the current account, and another one is the capital account.
The formula to calculate the Balance of Payments (BoP) is -
BoP = Current Account + Financial Account + Capital Account + Balancing Item
The current account keeps all the records of imports and export of goods and payments, mainly transferred payments. When we subtract imports from exports, we get a trade balance. Two situations arise here, the first one is when export exceeds the imports which are known as a trade surplus, and the second one is when import exceeds the export, which is known as a trade deficit.
During the fiscal year 2019-20, first time in 13 years, India witnessed a trade surplus due to higher export and low import which was 0.1% of GDP.
By adding net transfers of services to the trade balance, we get the current account balance.
The capital account contains all overseas acquisitions and sales of assets such as money, stocks, bonds, and other securities are recorded.
Financial accounts record the flow of money transferring to our country and into the country. We have assumed that the economy cannot work with the rest of the world but is it true?
In the real world, an economy can interact with other countries' economies, and that economy is known as an Open Economy.
An economy of a country that can interact with other countries' economies can help their country to grow because of the following three factors:
Consumers can decide whether to use domestic goods or foreign goods and this gives them a choice.
An investor can choose whether to invest in the domestic market or the international market.
An organization can choose where to locate its factory or production line. They get the choice of location because in some countries labor is more affordable.
These three factor helps the country to grow more and open up to the international economy. For example, India is also an open economy.
When a consumer consumes another country's products, it increases the import and when a firm sells in the international market it helps the import section go up and the earnings of the economy go up.
You cannot purchase a foreign good with the domestic currency and that is the problem a country faces when its economy is open to the world. To solve this problem, a county states that other countries can exchange the domestic currency with them at a fixed price or in exchange for a commodity like gold.
International trade can influence the demand and income of a country and it happened in two ways -
First, when a consumer purchases a forging good or service the demand for that good or service increase but it also decreases the income of the domestic economy same goes another way around.
Second, when someone in another country purchases our products, it increases the import and the income of an economy too.
We can get the total foreign trade by adding all the exports and imports in a period.
Let us now learn about foreign exchange.
The exchange rate is the price of one currency in terms of another.
For example, assume you want to go to the USA for vacation or to meet your relatives. Now you know that in the USA they have their currency, and Indian currency won’t work there. Before going to the USA, you have to exchange the Indian rupee with the US dollar and to do that you can go to the foreign exchange market.
There are two ways we can define exchange rates.
First one is - when the amount of domestic money is needed to purchase one foreign currency unit, i.e. dollar to the euro exchange rate. You can say that with 1 dollar you can buy 0.94 euros.
Second is - the other way around when you want to purchase foreign currency (not exchange), which is known as the bilateral nominal exchange rate.
1. What is BOP imbalance, and what causes it?
Ans. The imbalance in the Balance of Payments occurs when total receipts are greater than Total Payments. It is known as its surplus or deficit status.
2. What is Mercantilism?
Ans. This goes back to the 16th century the theory of mercantilism was dominating the European society. The theory was simple; it states that if a country wants to grow its economy they have to seek trade surplus which means they should export more and lower the import.
3. What is reserve account entry confusion?
Ans. The inclusion of the reserve account entry, which is part of the capital account, in the BoP accounts is a common source of confusion. The reserve account keeps track of the central bank's activities. If it is removed, the BoP might be either in excess (implying the central bank is building up foreign exchange reserves) or in deficit (implying the central bank is depleting foreign exchange reserves) which implies the central bank is running down its reserves or borrowing from abroad.
4. What is a Reserve asset?
Ans. The reserve asset is the currency or other store of value that is typically used by nations for their foreign reserves under BoP and international monetary systems. BoP imbalances often appear as surplus countries amassing reserve asset hoards, while deficit countries build debts denominated in the reserve asset or at the very least deplete its supply.
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