Class 12 Economics is divided into two groups, Macroeconomics and Indian Economic Growth, as we all know. Class 12’s Balance of Payments Chapter is an important part of the macroeconomics section. This blog on Balance of Payment Class 12 study notes will give you a thorough description of what balance of payment is, how it works, and how it is divided into current and capital accounts. Class 12 of the balance of payment tries to explain the balance of trade and how it differs from the balance of payment, as well as autonomous products, accommodating items, and other topics. So if you wish to know or want to do a quick revision on this chapter of Balance of Payment Class 12, then must read this blog till the end.
Table of Contents
What is Balance of Payment or BOP?
A country’s balance of payments is a comprehensive record of all economic transactions between its citizens and residents of other countries for a particular time span.
Simply put, the balance of payment is a statement that records all transactions between companies, government bodies, and individuals from one country to another over a specified period of time. The statement contains all transaction information, providing the authority with a good picture of the fund flow.
Structure of Balance of Payment accounting
- Transactions are reported in the balance of payments accounts.
- Any foreign transaction that a country conducts results in an equal sum of credit and debit entries.
- The BOP accounting must always balance i.e., debit must be equal to credit, as international transactions are recorded.
- To “balance” the BOP accounts, the balancing item Errors and omissions must be added.
- By convention, debit items are denoted by a minus sign and credit items are denoted by a plus sign respectively.
- In the Balance Of Payment, the transactions can be categorised as:
- Goods and services account
- Unilateral transfer account
- Long-term capital account
- Short-term private capital account
- Short-term official capital account
Accounts of Balance of Payments
- Current Account – The current account is basically a record of export and import of goods and services.
- Capital Account – The Capital Account is a record of all such transactions between normal residents of a country and rest of the world which includes sale and purchase of foreign assets and liabilities during a given accounting year.
- Balance of trade – Balance of trade can be defined as the net difference of import and export of items between the residents of a country and the rest of the world.
- Autonomous items – Can be defined as those items of balance of payment which are related to such transactions that are determined by the motive of profit maximisation and not to maintain equilibrium in balance of payments. These items are recorded as the first items before calculating the deficit or surplus in the balance of payment a/c. These items are also known as ‘Above the Line items’ in balance of payment.
- Accommodating items – Accommodating items include those transactions that take place as a result of other activity in balance of payment. Also known as ‘Below the Line items’ in balance of payment.
- Deficit of Balance of Payments Account – A situation wherein the total inflow of foreign exchange on account of autonomous transactions is less than the total outflow on account of such transaction.
- Foreign exchange rate – In simple terms, foreign exchange rate may be defined as the rate at which other currencies are bought by a country. The system of exchange has been listed as follows in Balance of Payments Class 12:
- Fixed exchange rate
- Flexible exchange rate.
Note: When we discuss the system of fixed exchange rate, it is important to know that, in a system of fixed exchange rate, rate of exchange is determined by the government in power or the Monetary Authority of the country. In contrast, in a flexible exchange rate system, the exchange rate is dictated by market forces. Foreign exchange demand is inversely proportional to the flexible exchange rate, which means that as the flexible exchange rate increases, so does foreign exchange demand, or vice versa.
Merits and Demerits of System of Exchange
Tabulated below are the certain merits and demerits of the system of exchange –
|Attracts foreign capital
|Neglects the concept of free market
|Makes sure inflation is in check
|Often results in over evaluation or undervaluation of currency.
|Stabilises exchange rate
|No automatic adjustment in BOP
|Involves promotion of international trade and capital movement
|Need to hold foreign exchange reserves.
What are the main sources of demands of foreign exchange?
- To access goods and services from across the world.
- To invest financial assets like bonds and equity shares in a foreign country.
- To speculate the value of the foreign currency.
- To invest directly in shops, factories, buildings in foreign countries.
- The demand for foreign tours.
Now, the supply of foreign exchange is directly proportional to the foreign exchange rate i.e., if the foreign exchange rate rises, the supply of foreign exchange also rises.
Sources of Supply of Foreign Exchange
- International purchase in the domestic market.
- International investment in the domestic market.
- Remittances by non-residents living abroad.
- Export of necessary goods and services.
- Flow of foreign exchange due to speculative purchases by N.R.I.
- Foreign direct investment and portfolio investment.
Tabulated below are the merits and demerits of the system of flexible exchange rate –
|Automatic adjustment in the ‘balance of payments.
Results inefficiency in the allocation of resources.
Ensures easy transfer of capital and trade.
Promotes venture capital and overcomes the problems of over-evaluation or undervaluation of currency.
|Creates market instability. Does not promote international trade or investment.
Encourages speculations and fluctuation in future exchange rates.
Some Important Definitions
- Determination of Equilibrium Foreign Exchange Rate: Equilibrium FER is the rate at which demand for and supply of foreign exchange is equal. In a free market situation, equilibrium FER is determined by market forces i.e., demand for and supply of foreign exchange.
- Devaluation of a currency: The lowering of the external value of a domestic currency by the government or monetary authority of a country officially, is known as the devaluation of the currency.
- Revaluation of a currency: The rise in the external value of a domestic currency by the government or monetary authority of a country officially, is known as revaluation of the currency.
- In currency depreciation: A situation wherein there is a fall in the value of the domestic currency, in terms of foreign currency due to change in demand and supply of the currency under a flexible exchange rate system.
- In currency appreciation: A situation wherein there is a rise in the value of the domestic currency in terms of foreign currency due to the change in demand and supply of the currency under a flexible exchange rate system.
- The managed floating system is a system in which the central bank allows the exchange rate to be determined by market forces but also makes sure it intervenes at times to influence the rate. For instance, when the central bank finds the rate is too high, it starts selling foreign exchange from its reserve to bring it down.
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