Open Economy Macroeconomics — the Balance of Payments and the Exchange Rate
Autonomous and Accommodating Transactions — When the BoP Is in Deficit
In the accounting sense the BoP always balances, because every rupee that comes in is matched by a use. The economically meaningful balance comes from separating transactions by motive. Autonomous transactions are made for their own sake — a firm exporting for profit, an investor buying shares — and are said to be "above the line". Accommodating transactions are made to cover the gap the autonomous ones leave — chiefly the central bank drawing down or adding to its foreign exchange reserves — and are "below the line".
- BoP deficit: autonomous payments exceed autonomous receipts, and the gap is financed by running down the official reserves.
- BoP surplus: autonomous receipts exceed autonomous payments, and the reserves rise.
- Official reserve transactions — the central bank's sales and purchases of foreign exchange — are the accommodating item. Worked: a current-account deficit of 40 with an autonomous capital-account surplus of 25 leaves an overall deficit of 15, so the reserves fall by 15.
- Errors and omissions is the balancing item for transactions that could not be recorded accurately.
The Foreign Exchange Market — Demand, Supply and the Rate
The foreign exchange rate is the price of one currency in terms of another — for instance, the number of rupees needed to buy one US dollar. If the rupee price of a dollar rises (say, from ₹80 to ₹84 in an illustration), the rupee has become cheaper: it has lost value against the dollar. Read the quotation carefully, because "the exchange rate rose" means the domestic currency fell when the rate is written as rupees per dollar.
| Demand for foreign exchange comes from… | Supply of foreign exchange comes from… |
|---|---|
| Imports of goods and services | Exports of goods and services |
| Residents travelling or studying abroad | Foreign tourists visiting the country |
| Residents buying assets abroad | Foreign investment flowing in (FDI, FPI) |
| Speculators expecting the foreign currency to rise | Remittances sent home by residents working abroad |
Under a flexible (floating) exchange rate, the rate is set by demand and supply in this market with no government target. When Indians want more dollars — say, because foreign holidays become popular — the demand curve for dollars shifts right and the rupee price of the dollar rises: the rupee depreciates. A cheaper rupee makes Indian exports cheaper for foreign buyers and imports dearer for Indians, which in time tends to raise exports and lower imports.
| System | How the rate is set | A fall in the domestic currency's value is called |
|---|---|---|
| Flexible (floating) | Market demand and supply | Depreciation (a rise is appreciation) |
| Fixed (pegged) | Set by the government; the central bank buys and sells to hold it | Devaluation — a deliberate official cut (a rise is revaluation) |
| Managed floating | Market-determined, but the central bank intervenes to smooth sharp swings | Depreciation |
Key takeaways
- The BoP records all transactions between residents and the rest of the world in a year; inflows are credits, outflows debits.
- Current account: goods, services, income and transfers. Capital account: FDI, FPI, loans and banking capital — anything that changes assets or liabilities.
- Balance of trade = exports of goods − imports of goods; services, income and transfers belong to the current account balance.
- Autonomous transactions are made for their own sake; accommodating ones — official reserve transactions — cover the gap.
- A BoP deficit is financed by running down reserves; a surplus adds to them.
- A rise in rupees per dollar is a fall in the rupee; depreciation makes exports cheaper abroad and imports dearer at home.
- Depreciation and appreciation happen under a float; devaluation and revaluation are official acts under a fixed rate; India follows a managed float.
Practice questions (8)
Attempt each one before opening the answer. Every explanation names the tempting wrong option as well as the right one, because that is where marks are lost.
Which of the following is recorded in the capital account of the balance of payments?
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Answer: C — Foreign direct investment in an Indian company
FDI gives a foreigner an ownership claim on an Indian enterprise, so it changes the country's liabilities — a capital-account item. Software exports are services and crude oil imports are goods, both current account, and remittances are one-way transfers that change no asset or liability, so they too sit in the current account.A country's exports of goods are ₹300 crore and its imports of goods are ₹420 crore. Its balance of trade is:
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Answer: A — A deficit of ₹120 crore
Balance of trade = exports − imports of goods = 300 − 420 = −120, a deficit of ₹120 crore. Calling it a surplus reverses the sign, ₹720 crore adds the two flows, and the accounting balance of the whole BoP says nothing about the trade balance, which is only one part of it.If the exchange rate moves from ₹75 per US dollar to ₹78 per US dollar, the rupee has:
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Answer: D — Depreciated against the dollar
It now takes more rupees to buy one dollar, so each rupee is worth less — the rupee has depreciated, and the dollar has appreciated. Reading the higher number as a stronger rupee is the standard slip; revaluation is a deliberate official rise in value under a fixed rate, which is the opposite direction anyway.A depreciation of the rupee is most likely to:
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Answer: B — Make Indian exports cheaper for foreign buyers
With a cheaper rupee, a foreign buyer needs fewer dollars to buy the same rupee-priced Indian good, so exports become cheaper abroad. For the same reason imports and foreign travel cost Indians more rupees, not fewer, and traded-goods prices are exactly what the exchange rate moves.The difference between devaluation and depreciation of a currency is that:
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Answer: C — Devaluation is an official cut; depreciation is a market-driven fall
Both are falls in the currency's value; what differs is who causes them. Devaluation is announced by the government under a fixed exchange rate, while depreciation is the result of demand and supply under a floating rate. Swapping the government and the market reverses the definitions, and neither word describes a rise in value.In the balance of payments, official reserve transactions are classified as:
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Answer: B — Accommodating transactions that cover the gap
The central bank buys or sells foreign exchange not for profit but to settle the gap left by all the autonomous transactions, which makes these the accommodating, below-the-line item. Autonomous transactions are undertaken for their own sake, transfers are one-way current-account flows, and FDI is an autonomous capital-account item.In ₹ crore: exports of goods 500, imports of goods 650, net services +120, net income −20, net current transfers +60. The current account shows:
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Answer: D — A surplus of ₹10 crore
Current account = (500 − 650) + 120 − 20 + 60 = −150 + 160 = +10, a surplus of ₹10 crore. ₹150 crore deficit is the trade balance alone, ₹30 crore deficit stops after adding services, and ₹50 crore surplus treats the net income of −20 as +20.A country has a current-account deficit of ₹40 crore and an autonomous capital-account surplus of ₹25 crore. To settle the balance of payments, its central bank's foreign exchange reserves will:
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Answer: A — Fall by ₹15 crore
Autonomous transactions leave an overall deficit of 40 − 25 = ₹15 crore, which must be financed by selling foreign exchange from the reserves, so they fall by ₹15 crore. A rise would follow from a surplus, not a deficit; ₹65 crore adds the two balances instead of netting them; and the reserves cannot stay unchanged while an autonomous gap remains.