Test: Balance of Payments -1 - UGC NET MCQ

Key Points

• The key element in any country's economic development is foreign trade.
• All imports and exports into and out of India are considered part of the country's foreign trade.
• Such operations are managed by the Ministry of Commerce and Industry at the Central Government level.

Important Points

• Payment of imports in rupees, this option is not a problem for India's foreign trade instead it is favourable condition for India's Foreign Trade.
• Increasing Quantity of exports is not a problem for foreign trade because it will boost balance of payment of economy.
• Unfavourable terms of trade can cause problems in foreign trade, like payment for export in international currency etc.

Key Points

• Disequilibrium is a lack of balance or harmony in a specific market or economy. This is usually in terms of supply and demand, where one far exceeds the other, resulting in a significant imbalance.
• Market disequilibrium often results in market instability, inefficient market activity, and substantial fluctuations in market variables, such as prices.
• Disequilibrium may also refer to a situation in which a country has a strong deficit or surplus in its balance of payments.
• There are several types of disequilibrium. Three common types are cyclical, secular, and structural.

Important Points

• Secular  disequilibrium - Secular disequilibrium (also known as long-run or long-term disequilibrium) is a type of disequilibrium that persists over a prolonged period because of changes in the fundamental underlying factors in an economy. These changes can be due to population growth, technological change, or other long-term trends.
• Structural disequilibrium - The term structural disequilibrium refers to a situation in which changes in the supply and demand for exports and/or imports lead to a disequilibrium in a country's balance of payments. This type of disequilibrium often results from changes in technology, government policy, or the economy.
• Cyclical disequilibrium - It occurs on account of trade cycles. Depending upon the different phases of trade cycles like prosperity and depression, demand and other forces vary, causing changes in the terms of trade as well as growth of trade and accordingly a surplus or deficit will result in the balance of payments.

Hence, the correct answer is Transactional disequilibrium

The most relevant approach in this case is the absorption approach. Here's why:

• Absorption approach: This framework focuses on the demand and supply balance within an economy. It posits that the trade balance (difference between exports and imports) is determined by the difference between aggregate demand (domestic expenditure + exports) and aggregate supply (domestic output). If aggregate demand exceeds aggregate supply, the country tends to import more and have a trade deficit. Conversely, if aggregate supply exceeds aggregate demand, the country tends to export more and have a trade surplus.
• Monetary approach: While the monetary approach also examines the balance of payments, it primarily focuses on the relationship between money supply and the exchange rate. While it indirectly connects to output through its impact on investment and trade, it doesn't directly explain the trade balance based on demand and supply dynamics.
• Keynesian approach: This approach emphasizes the role of aggregate demand in influencing economic activity. While it acknowledges the potential impact of output on trade through income effects, it doesn't explain the trade balance as a consequence of the direct interplay between demand and supply as the absorption approach does.
• Elasticity approach: This approach focuses on the responsiveness of trade flows to changes in prices and income. While it can help understand how domestic output prices might affect import and export quantities, it doesn't provide a complete explanation for the trade balance based on the broader demand and supply framework as the absorption approach.

Therefore, based on the options provided, the absorption approach is the most appropriate in explaining the relationship between domestic output and trade balance. It offers a clear analytical framework to understand how domestic demand and supply dynamics translate into trade imbalances.

Assertion is correct as the Financial Account does indeed focus on monitoring a country's holdings of assets abroad and foreign holdings within its borders.

The Reason statement is also correct as it mentions the inclusion of financial derivatives like options and futures in the account.

However, the Reason statement does not directly explain why the Financial Account focuses on monitoring a country's holdings of assets abroad and foreign holdings within its borders. The Reason is related to the content of the Financial Account but does not provide a direct explanation for the assertion. Hence, Option B is the correct answer.

Statement (I): The capital account consists of long-term capital transactions only.

1. The capital account of BOP records all those transactions, between the residents of a country and the rest of the world, which cause a change in the assets or liabilities of the residents of the country or its government.
2. It is related to claims and liabilities of financial nature.
3. The capital account records all transactions made between entities in one country with entities in the rest of the world.
4. These transactions consist of Investments to and from abroad, Change in Foreign Exchange Reserves, Borrowings and lendings to and from abroad
5. The capital account measures the changes in national ownership of assets. 

Thus, the statement I is incorrect.

• The Assertion, stating that the Balance of Payments is crucial for understanding a country's economic health, is accurate. The Balance of Payments provides insights into a nation's financial transactions with the rest of the world, impacting its economic stability.
• However, the Reason, suggesting that countries with a consistent surplus are financially stronger, is not entirely correct. While a surplus in the Balance of Payments can indicate financial strength, it is not always the case. A surplus can also result from other factors like government policies or external shocks.
• Therefore, Assertion (A) is true, but Reason (R) is false. The Reason is not a correct explanation of the Assertion, leading to Option C being the correct answer.

Balance of Payment:

• The country's economic dealings with the rest of the world for a given time period, often a year, are documented in the balance of payments (BoP).
• It is a comprehensive accounting balance sheet that covers both debit and credit transactions for the entire nation.
• When the current account balance is totally financed by foreign lending and the non-reserve capital account is equal to zero, the country is considered to be in balance of payments equilibrium.
• A balance of payments deficit means the country imports more goods, services, and capital than it exports. It must borrow from other countries to pay for its imports.

Important Points
Correction of deficit balance of payment:

• Import controls: To correct the deficit balance of payment the imports must be reduced. Implementation of the import control measures will result in curbing imports in the country and will therefore correct the deficit balance of payment. 
• Export promotion:  To correct the deficit balance of payment the exports of the country should be increased, and the export promotion measures will help in increasing the exports in the country.
• Foreign exchange control: Foreign exchange control result in rationing of the foreign exchange by the central bank which will limit the supply of the foreign currency in the country. Rationing will allow use of foreign currency for only specific purposes which will ultimately reduce the deficit balance of payment.
• Devaluation: Devaluation is the deliberate reduction in the external value of the currency country. Devaluation will result in expensive imports and will motivate the exporters to export more. Hence, the balance of payment fill improve in case of deficit

Key Points

• BOP is a flow concept as it is measured over (during) a period of time.
• Since BOP is measured over a time interval, it can be said that they have an element of time attached to them. Similarly, current account is also a flow variable. 

Important Points

• The term ‘balance of payments is the’ sum or aggregate of its current account and capital account.
• Current account and capital account will always move in the opposite directions.
• A deficit on current account will always meet with a matching surplus on capital account, and conversely a surplus on current account will match with a deficit on current account. And in the ultimate analysis, an economy’s BOP will be in balance i.e., there will be no deficits and surpluses in aggregate.
• The capital account also includes the flow of taxes, purchase and sale of fixed assets etc., by migrants moving out/into a different country. The deficit or surplus in the current account is managed through the finance from the capital account and vice versa.

• The Assertion is correct as the Balance of Payments indeed offers a comprehensive look at a country's economic transactions with the world.
• The Reason is also accurate as the BOP helps in determining whether a country has more financial inflows (surplus) or outflows (deficit).
• The Reason serves as a correct explanation for the Assertion, as the BOP not only but also interprets whether a country is economically strong (surplus) or facing challenges (deficit).

Key Points

• The balance of payments summarizes an economy's international economic dealings. 
• These transactions consist of transfer payments as well as the export and import of products, services, and financial assets (like foreign aid).
• The current account, the capital account, and the financial account are the three primary subcategories of the BOP.
• The influx and outflow of goods and services into a nation are represented by the current account.
• All overseas capital transfers are noted in the capital account.
• International monetary flows associated with investments in companies, properties, bonds, and stocks are recorded in the financial account.
• The BOP should be 0 when the current account is in balance with the total of the capital and finance accounts, but this rarely happens.