First read the Part-1 from the link given below.
Balance of Payments- Part 2
Exchange rate: An exchange rate is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in relation to another currency. For example, an exchange rate of 80 INR to the United States dollar means that INR 80 will be exchanged for each US$1 or that US$1 will be exchanged for each INR 80. This is a Bilateral Nominal Exchange Rate.
Real Exchange rate: It measures the ratio of foreign to domestic prices. This means that real exchange rate compares foreign and domestic goods to find out parity in prices of a basket of products.
Real Exchange Rate = e * (Pf/ P)
Where e is the nominal exchange rate, Pf is the price of a particular good abroad and P is the price of that same good in domestic market.
Purchasing Power Parity (PPP):
Purchasing power parity (PPP) is a popular metric used by macroeconomic analysts that compares different countries’ currencies through a “basket of goods” approach.
where: S= Exchange rate of currency 1 to currency
P1= Cost of good X in currency 1
P2= Cost of good X in currency 2
A real exchange rate of 1 means that there is parity between price levels of products in two countries
real exchange rate > 1 means that foreign products are costlier/ expensive than domestic products.
Real exchange rates are used to determine international competitiveness of products.
What Is the Real Effective Exchange Rate – REER?
The real effective exchange rate (REER) is the weighted average of a country’s currency in relation to an index or basket of other major currencies. The weights are determined by comparing the relative trade balance of a country’s currency against each country within the index.
What Is the Nominal Effective Exchange Rate (NEER)?
The nominal effective exchange rate (NEER) is an unadjusted weighted average rate at which one country’s currency exchanges for a basket of multiple foreign currencies. The nominal exchange rate is the amount of domestic currency needed to purchase foreign currency.
Exchange rate regime
An exchange rate regime is the way a monetary authority of a country or currency union manages the currency in relation to other currencies and the foreign exchange market.
There are three broad exchange rate systems—currency board, fixed exchange rate and floating rate exchange rate. A fourth can be added when a country does not have its own currency and merely adopts another country’s currency.
Fixed Exchange Rate: It is also called the pegged exchange rate. The par value of the domestic currency is set with reference to a selected foreign currency (or precious metal or currency basket). The exchange rate fluctuates with a range (usually +1% of the par value).
A few countries (such as Micronesia and San Marino) select another country’s currency as legal tender. This is called Dollarization, since the selected foreign currency is usually the US dollar.
The central bank of the country promises to convert domestic currency (on demand and at any point in time) for a predetermined number of units of a specific foreign currency. In order to fulfil this promise, the central bank has to hold foreign exchange reserves in the selected foreign currency. Usually a government decides to adopt a currency board when the holders of domestic currency lose confidence in it is as a medium of exchange, triggered by rampant inflation, unbridled government debt (resulting in fiscal deficits) and recession. A currency board is expected to restore faith in the domestic currency.
The first currency board was set up in Mauritius in 1849.
Variants of a Floating Exchange Rate System:
- Managed Float:
A floating exchange rate (or flexible exchange rate) is the opposite of the fixed exchange rate. Market forces determine the value of the domestic currency against a selected foreign currency. A managed float (or dirty float) is a floating exchange rate in which the monetary authorities influence the exchange rate (through direct or indirect intervention without specifying the target exchange rate). India is on a managed float.
- Free Float or Clean Float:
Here, the exchange rate is purely determined by market forces (demand and supply of the currency).
In India, we follow a managed floating exchange rate system. Here, the RBI interferes to manage volatility in floating exchange regime. To stop depreciation of rupee, RBI should sell dollars from its forex reserve and to stop appreciation of rupee, RBI should purchase dollars from the market.
Rupee Convertibility: Indian rupee is fully convertible only in the current account and not in the capital account. This means one can import and export goods or receive or make payments for services rendered. However, investments and borrowings are restricted.
LRS: The Liberalised Remittance Scheme (LRS) of the Reserve Bank of India (RBI) allows resident individuals to remit a certain amount of money during a financial year to another country for investment and expenditure. According to the prevailing regulations, resident individuals may remit up to $250,000 per financial year. This money can be used to pay expenses related to travelling (private or for business), medical treatment, studying, gifts and donations, maintenance of close relatives and so on.
Gold Standard: The gold standard is a monetary system where a country’s currency or paper money has a value directly linked to gold. With the gold standard, countries agreed to convert paper money into a fixed amount of gold. A country that uses the gold standard sets a fixed price for gold and buys and sells gold at that price. That fixed price is used to determine the value of the currency. For example, if the U.S. sets the price of gold at $500 an ounce, the value of the dollar would be 1/500th of an ounce of gold.
1944 Bretton Woods Agreement
The 1944 Bretton Woods Agreement set the exchange value for all currencies in terms of gold. It obligated member countries to convert foreign official holdings of their currencies into gold at these par values.
The United States held the majority of the world’s gold. As a result, most countries simply pegged the value of their currency to the dollar instead of gold. Central banks maintained fixed exchange rates between their currencies and the dollar by buying their own country’s currency in foreign exchange markets if their currency became too low relative to the dollar. If it became too high, they would print more of their currency and sell it. As a result, most countries no longer needed to exchange their currency for gold, as the dollar had replaced it.
End of the Gold Standard
By the 1970s, the United States stockpile of gold continued to decline as President Nixon’s economic policies created stagflation. Double-digit inflation reduced the eurodollar’s value, and more and more banks started redeeming their holdings for gold. The United States could no longer meet this growing obligation.
That’s when Nixon changed the dollar/gold relationship to $38 per ounce. He no longer allowed the Fed to redeem dollars with gold, which made the gold standard meaningless. The U.S. government repriced gold to $42.22 per ounce in 1973 and then decoupled the value of the dollar from gold altogether in 1976. The price of gold quickly shot up.
Triffin dilemma: Triffin paradox is the conflict of economic interests that arises between short-term domestic and long-term international objectives for countries whose currencies serve as global reserve currencies. This dilemma was identified in the 1960s by Belgian–American economist Robert Triffin, who pointed out that the country whose currency, being the global reserve currency, foreign nations wish to hold, must be willing to supply the world with an extra supply of its currency to fulfil world demand for these foreign exchange reserves, thus leading to a trade deficit.
Countries with unsustainable current account deficits can run into difficulties. If the deficit is large and the economy is not able to attract enough inflows of foreign investment, then their currency reserves will decrease. The situation might worsen leading the country to seek emergency borrowing from institutions such as the International Monetary Fund that may lead to external debt. BoP crisis is also known as the currency crisis. India faced BoP crisis in 1990-91.
1990-1991 BOP Crisis in India
• It began in the year 1985 when India started having a balance of payment problems and towards the end of the year 1990, it was in a serious economic crisis.
• The government was on brink of default with reserves barely enough to finance even 20 days’ worth of imports which led the Indian government to pledge gold reserves to the International monetary fund (IMF) to get a loan in order to overcome this balance of payment crisis
• The BOP crisis hit the country in the year 1990 but the journey of the crisis had been building for at least a half a decade, preceding the year of 1991.
• The rising fiscal deficit and gradually increasing overvaluation had all resulted in the rising imbalance in the balance of payment of the country.
• Improper exchange rate adjustment also contributed to the crisis.
India approached the World Bank and IMF for loan to manage the crisis. International agencies asked India to bring in the much-required reforms of 1991, also called LPG (Liberalization, Privatization and Globalization). The New Economic Policy brought in structural and stabilisation reforms.
INDIA’S FOREIGN TRADE POLICY
Also called EXIM (Export Import) Policy
Imports: Import refers to goods that we buy from other countries. E.g. Crude Petroleum, gold etc.
Export: It refers to goods that we sell to other countries. E.g. gems & jewellery, marine products etc.
Composition of trade: Composition of foreign trade means major commodities in which India trades.
Terms of trade: TOT is expressed as a ratio that reflects the number of units of exports that are needed to buy a single unit of imports.
Trade policy refers to the regulations and agreements that control imports and exports to foreign countries.
• India’s foreign trade policy is regulated by Foreign Trade (Development & Regulation) Act, 1992.
• The main objective of the Foreign Trade (Development and Regulation) Act is to provide the development and regulation of foreign trade by facilitating imports into and augmenting exports from India.
• EXIM Policy also know as Foreign Trade Policy is prepared and announced by the Central Government (Ministry of Commerce). DGFT (Directorate General of Foreign Trade) is the main governing body in matters related to EXIM Policy
The Government of India for the first time introduced the Indian Exim Policy in 1992 for the duration of 5 years. The present foreign trade policy covers five years i.e. from 2015 to 2020.
TARGETS OF INDIA’s FTP 2015-20
Mid term review of Foreign Trade Policy
- Scope of Merchandise Exports from India Scheme (MEIS) and Service Exports from India Scheme (SEIS) enhanced.
- MEIS incentive raised for ready-made garments and made- ups by 2% (additional annual outgo Rs 2,743 crore).
- Across-the-board increase of 2 per cent in existing MEIS for exports by MSMEs/labour incentive industries (Rs 4,567 crore).
- SEIS incentives raised by 2 per cent with a view to boosting services sector exports (Rs 1,140 crore).
- To focus on improving ease of trading across borders for exporters and importers.
- Professional team to handhold, assist and support exporters in accessing markets, meeting regulatory norms.
- New Logistics Division to promote integrated development of the logistics sector.
- State-of-the-art trade analytics division in DGFT for data-based policy actions.
- New agricultural exports policy to focus on increasing exports of value-added agri products.
- New Services Division in DGFT to examine Exim policies and procedures to push services exports.
- To enhance
participation of Indian industry in global value chains.
1. What is the limit under Liberalized Remittance Scheme of the RBI?
- $1,00,000 per year
- $1,50,000 per year
- $2,00,000 per year
- $2,50,000 per year
- $3,00,000 per year
Solution: (d) $2,50,000
According to the prevailing regulations, resident individuals may remit up to $250,000 per financial year under LRS.
- _1_____is the difference between country’s exports and imports?
- Trade Deficit
- Current Deficit
- Balance of Trade
- Balance of Payment
- Capital account surplus
Solution: (c) Balance of Trade
Balance of Trade (BOT) includes only the trade of visibles, whereas current account includes both visibles and invisibles.
- 2_________is when a country begins to recognize the U.S. dollar as a medium of exchange or legal tender alongside or in place of its domestic currency.
- Fixed Peg
- Crawling Peg
- Currency Board
- None of the above
Solution: (a) Dollarization
Dollarization is the use of a foreign currency (Dollar) in parallel to or instead of the domestic currency. It is a form of currency substitution.
- 3.Transfer payments received by an Indian resident will be accounted under which head?
- Capital Account
- Forex transaction
- Reserve Tranche
- Invisibles under current account
- Visibles under current account
Solution: (d) Invisibles under current account
- 4. Which of the following is not an effect of globalization?
- More choice for consumers
- Better availability of capital
- Lower costs
- All of the above
Solution: (e) All of the above
Globalization helps economies to focus on their comparative advantage. It helps the economies to produce those goods in which they specialize and import other goods from rest of the world. This promotes innovation, more variety for consumers, lower costs, more availability of capital.
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