Indian Economy · Topic 11 of 20
External sector accounting and exchange rate mechanisms
The Basics
An open economy trades and invests with other countries. A closed economy trades only within its own borders. An open economy buys and sells goods, services, capital and labour across borders.
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The balance of payments is a record of a country's dealings with the world. It covers all transactions in one year, usually. It includes trade, investment, loans and gifts. It is not just exports and imports of goods. It is not just government-to-government dealings.
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The current account is part of the balance of payments. It records regular money flows with other countries. This includes trade in goods, trade in services, income from abroad, and transfers. It does not include buying or selling foreign assets or loans. It does not include Special Drawing Rights either. These belong to the capital account.
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The capital account records money moving for investment, loans or assets. It does not record goods, services or income.
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Balance of Payments (BOP) equilibrium means inflows and outflows of foreign currency roughly match. Disequilibrium means a deficit or surplus builds up, because one side is consistently bigger than the other.
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A current account deficit (CAD) means a country spends more foreign currency than it earns. For example, it pays more for imports than it gets from exports. A small, well-financed current account deficit is normal for a growing economy. The real danger is not the deficit's size. The danger is how the deficit is paid for.
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The foreign exchange market (forex market) is where countries' currencies are bought and sold. It is not one building, but a network of banks and dealers. People in India need Dollars to pay for imports, study or travel abroad. People abroad need Rupees to buy Indian goods or invest in India. Buying and selling currencies sets the exchange rate. The exchange rate is the price of one currency in another.
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An exchange rate system is the rule a country uses to decide how much foreign currency its own currency can buy. There are three broad systems: fixed, flexible (floating), and managed floating, which mixes the two.
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An exchange rate is the price of one currency in another currency. For example, one United States dollar may equal eighty-three rupees. Under a market system, demand and supply set this price.
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Purchasing Power Parity, or Purchasing Power Parity (PPP), finds a currency's real exchange rate. It shows how many units of a currency buy what one United States dollar buys there. Purchasing Power Parity rates are calculated by comparing prices of the same basket of goods across countries.
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Convertibility means a currency can be freely exchanged for other currencies. The government does not ask why foreign currency is needed. This applies to both residents and non-residents. It is the opposite of a closed, controlled currency system.
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The Liberalised Exchange Rate Management System (LERMS) was a transition step for India's rupee. It moved the economy from a fixed rate to a market rate. It used two exchange rates at the same time. So it is also called the dual exchange rate system.
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Countries trade with many partners, not just one. So one exchange rate cannot show total trade position. Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER) solve this problem. They show a currency's value against a basket of partner currencies.
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The impossible trinity is a central bank dilemma.
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Foreign exchange reserves are stocks of foreign money and foreign assets. A country's central bank holds them. It can use them quickly when needed.
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External debt means foreign-currency debt owed to foreign lenders. It covers the government, companies, and residents, not government alone.
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The Foreign Exchange Regulation Act 1973 (FERA) controlled foreign exchange use.
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