The Balance of Payments

All transactions that take place between the residents of the domestic economy and the
nonresidents or the rest of the world is accounted by the central bank of the country and recorded
in a statement called the Balance of Payments (BOP).

Trade Account = 1-5

Service Account = 2-6

Mode1  Cross border trade

Mode2 Consumption abroad

Mode3 Commercial Presence

Mode4 Movement of Natural Persons

4  Loans taken pr repaid by non residents and finqncial investment inward

Financial Investments = 1) FII Foreign Institutional Investment/Portfolio Investment (brings inflow of

money)  Short term and risky
2) Foreign Direct Investmnet (FDI)  deasl with GDP directly. Impacts Investmnet (I) in GDP formula.
 long term and less risky

8  loans taken/repaid abroad and investmnets made

Reserve Account happens when debit not equal to Credit.

If Credit>Debit  domestic currency appreciates; this affects exports; to prevent CB buys foreign
currency from market

Vice versa if Debit>Credit; domestic currency depreciates; this affects imports; to prevent CB sells
For curr in market
Transactions in the balance of payments determine and affect the exchange rate.
The determination of the exchange rate between two currencies is a function of the demand and
supply of the two currencies.
Echange Rate: In fact, all transactions on the debit side of the Balance of Payments (BOP) would
lead to a demand for foreign currency in UAE.
The supply of foreign currency, on the other hand, is on account of all transactions on the credit
side of UAE’s BOP, like

When demand for foreign curr increases, Dcurve shifts to right, leading from E E1  dollar
appreciates and domestic currency depreciates
Increase in supply of foreign curr increases, Scurve shifts to right, leading from S S1  dollar
depreciates; domestic currency appreciates
But UAE follows, fixe exchange rate regime

Exchange Rate Determination:

1) Fixed exchange rate system – eg UAE ( Intervention of UAE CB)
When crude oil rate increases  UAE’s import earnings increase, i.e UAE exports crude oil
supply curve shifts to right; USD decpreciates and UAE currency appreciates, In order to
maintain exchange rate at fixed rate; CB buys USD currency from market, this is artificial shift of
demand curve to right. Thus this shift is intervention. Thus maintain original level E. Since the
market forces of demand and supply in all countries do not restore stability in the BOP some
countrie like UAE have to follow a fixed exchange rate regime.
Vice versa when imports of goods increase
2) Flexible Exchange Rate: CB does not intervene. Market take control of shift in Suppluy
and Demand curve to influence exchange rate
IF BOP is in deficit  Debit>Credit; domestic curr depreciates and foreign currency
increases. Here imports fall and exports rise reducing deficit
3) Managed Float System – followed by India. Combination of above 2. CB will allow
fluctuations in D-S Curve upto a certain point and then it will intervene if economic
conditions may not withstand such a fluctuations.
If INR appreciates, exports become costly, growth suffers. If INR depreciates, imports
will be costly,(example oil), thus leads to inflation
Demand and Suppy of USD  Oil price increase, demand of USD shifts from D to D1,
thus shifting from E to E2(new Point). But CB cannot move to new E2, thus it shifts
supply curve by supplying dollar to market; S shifted to S1 thus E to E1. This is partial
change and not full change.

Foreign Exchange Reserves:

When Debit>Credit, demand for for curr is high; foreign currency appreciates, domestic
curr depreciates; to fill gap, CB sells foreign curr from market this transaction is made
to fill gap in credit side of BOP
Viceversa; CB buys foreign currency to maintain gap in debit side of BOP. Such purchase
is Foreign Exchange Reserves (FER). CB hold this and adds to BSheet as asset. Selling of
 foreign currency leads to depletion of amount in FER. The amount defines how many
more months it can support for India’s imports.

NEER and REER:

 NEER is the weighted average of bilateral nominal exchange rates of the home currency in terms
of foreign currencies
 terms of foreign currencies. Specifically,
n
 NEER = II (e/ei)w i
i =1
 the REER, defined as a weighted average of nominal exchange rates adjusted for relative price
differential between the domestic and foreign countries, relates to the purchasing power parity
(PPP) hypothesis
n
 REER = II [(e / ei) (P / Pi) ]w i
i=1
Where e : Exchange rate of Indian rupee against a numeraire, i.e., the IMF’s Special Drawing Rights
(SDRs) in indexed form

ei : Exchange rate of foreign currency ‘i’ against the numeraire (SDRs) (i.e., SDRs per currency i) in
indexed form,
wi : Weights attached to foreign currency/ country ‘i’ in the index
n
II wi = 1
i =1
P : India’s wholesale price index (WPI),
Pi : Consumer Price Index of Country i (CPIi), and
n : Number of countries/currencies in the index other than India.

Money in demand curve

Macro basic: 1) Reduce unemployement 2) Reduce Inflation 3) Increase growth
2 policy interventions  Monetary Policy, Fiscal Policy
• The aggregate demand equation is stated as follows:
• Y= C+I+G+NX( Y=GDP, C= consumption, I = Investment , G= Government expenditure on
goods and services and NX is net export).
• Monetary policy intervention happens in case of Investment and CAD through capital flows.

• There are thus three sources / channels through which monetary policy works by the intervention
of the central bank viz; (a) quantity of money (reserve money and money stock), (b) Price of
money( interest rate) and exchange rate

• Money: Money is a means of payment or medium of exchange; a store of value ; a unit of account
and a standard of differed payments.

• Medium of exchange: a means(assets) of payment generally accepted in exchange.

• Store of value: an asset which maintains value over time

• Unit of account: a unit in which prices are quoted and books kept. Rupee is unit of account in
India and Dollar is unit of account in USA.

• Standard of deferred payments: money unit are used in long term transactions such as loans.
 • Money can, therefore, be defined for policy purposes as the set of liquid financial assets, the
variation in the stock of which could impact on aggregate economic activity.

Monetary = base/high powered money + price of money(interest rate)

• Three motives of holding money: 1) Transaction demand: this measures amount of money money
needed to buy basic goods and services that they use. “Demand for money arising from the use of
money in making regular payments”

2) Precuationary demand: “Demand for money to meet unforeseen contingencies”.

3) Speculative Demand: “Demand for money arises from uncertainties about money value of other
assets that an individual can hold”. Demand for money for additional transactions other than basic
necessary ones for living.

• TD=f(Y) PD= f(Y) SD =f(i)

• Demand for money(DM)= f( Y, i) (where Y=income and i= interest rate.)

• Thus, the money demand functions are trade off between the benefits of holding more
money versus the interest cost of doing so.

Supplu for money: CB provides moentary base – currency and bank reserves on which money
supply is built.

• M0= Base money or High Powered money (Bank notes and coins)

• M3= Broad Money or Money Stock

• Reserve Money (M0) = As on February 21, 2020 (in Rs. billion)

• M0 (a+b+c)=29,774.71 Y-o- Y growth 11.4 %

Components(a+ b +c)

(a)Currency in circulation (total money circulating in public) =23,577.02 Y-o-Y growth 11.9%
(b)Banker deposits with RBI (total money physicaaly present in banks vault)=5,863.30

(c ) other deposits with RBI(commercial bank reserves present in RBI) =334.39

Source(i+ii+iii+4-5)

(i)Net RBI credit to government= 9,344.52

(ii)RBI credit to Banks &Commercial Sector (NET DOMESTIC ASSETS (NDA))= -2,285.96

(iii)Net Foreign exchange assets of RBI=34,085.31 Y-O-Y (20.0%)

(iv)Government’s currency liabilities to the public =262.80

(v)Net non-monetary liabilities=11,631.96

**Google

Reserve money holds the topmost position in the RBI’s

monetary policy. Since it is mostly currency in circulation with
the people , reserve money decides the level of liquidity and
price level in the economy. Management of reserve money is
 thus very important to manage liquidity and price level
(inflation). 

Money Stock: Amount of money avaible at given period in time in economy

• As on February 14, 2020 ( in Rs. billion)

• M3 (a+b+c)=1,63,700.23 Y-o- Y growth 9.6 %

Components(a+ b +c)

(a)Currency with Public =22582.72 Y-o-Y growth 11.3 %

(b) Demand deposits= 14812.05 Y-o-Y growth 5.7 %

(c ) Time deposits = 125971.19 Y-o-Y growth 9.7 %

(d) Other deposits=334.27

Source(i+ii+iii+iv-v)

(i)Net Bank credit to government= 50002.66

(ii)Bank credit to Commercial Sector=106941.21 (Y-O-Y= 6.5%)

(iii)Net Foreign exchange assets of Baking Sector=36143.68 (Y-O-Y=21.9%)

(iv)Government’s currency liabilities to the public =262.80

(v)Net non-monetary liabilities= 11527.70