Balance of Payments Test - 11

The system of flexible exchange rates eliminates the need for official foreign exchange reserves, if the individual governments do not employ stabilization funds to influence the rate. Thus, the problem of international liquidity is automatically solved. In fact, the present shortage of international liquidity is due to pegging the exchange rates and the intervention of the IMF authorities to prevent fluctuations in the rates beyond a narrow limit.

The foreign exchange rate always fluctuates under flexible exchange rate and a domestic economy exports more when it's currency depreciates in the forex market and vice versa. Such adjustments are not possible under fixed regime . 

Fixed exchange rate had however a great flaw in that the countries with a large and persistent balance of payments deficits were losing gold and other foreign assets. This could not go on forever as evidently stock of gold and foreign currencies would have run out.
Countries with deficit bop found their international reserves dwindling which forced them to devalue their currency. The devaluation has an inflationary potential.
Due to depletion of reserves of gold and foreign cur­rencies, the countries with deficit balance of payments are forced to devalue their currency to over­come the deficit.

As countries can’t implement autonomous monetary policies under a metallic standard, they many import their trade partner’s inflation and unemployment rates. For example, if the inflation rate is increasing in a country, at the given exchange rate, its consumers may increase their demand for foreign goods, thus increasing the prices in other countries.

System of flexible exchange rates has been opposed on the ground that under it there is widespread speculation regarding ex­change rates of currencies which has a large destabilising effect on exchange rates.

 Current account includes a large variety of non- factor services (known as invisible items) sold and purchased by the residents of a country, to and from the rest of the world. Payments are either received or made to the other countries for use of these services.

Unilateral transfers include gifts, donations, personal remittances and other ‘one-way’ transactions. These refer to those receipts and payments, which take place without any service in return. Receipt of unilateral transfers from rest of the world is shown on the credit side and unilateral transfers to rest of the world on the debit side.

As current Account records all the actual transactions of goods and services which affect the income, output and employment of a country. So, it shows the net income generated in the foreign sector.

Fluctuating exchange rates cause changes in the price of imported and exported goods which, in turn, destabilise the economy of the country. Due to fluctuation  it becomes unable to take proper decisions regarding exports and imports of goods. Obviously, this has a damp­ening effect on the volume and growth of foreign trade.

 Floating exchange rates is subject to intervention from time to time by the monetary authorities, in order to resist fluctuations that they consider to be undesirable.

Normally the currency floats freely in the market - the value is determined by the forces of supply and demand for a given currency.

But the government and/or central bank of a country may decide to use intervention in the currency market as a way of manipulating its value to achieve given macroeconomic objectives.

Investments by rest of the world in shares of Indian companies, real estate in India, etc. Such investments from abroad are recorded on the positive (credit) side as they bring in foreign exchange.

 Investments by Indian residents in shares of foreign companies, real estate abroad, etc. Such investments to abroad be recorded on the negative (debit) side as they lead to outflow of foreign exchange.