Foreign Trade

Almost all the economies are open, interacting with each other. There will be exchange of 
i) Products (goods and services)
ii) Financial Assets
iii) Factors of production

The total foreign trade (export+import) as a proportion of GDP is the measure of degree of openness of an economy. In 2006-07, the share of foreign trade to the GDP was 35% (in case of India)

Balance of Payment (BoP)

It is a record of transactions in goods, services and assets between a country with external world.
Transactions are recorded under two accounts
i) Current Account
ii) Capital Account
iii) Errors and Omissions

(As per IMF definition, it includes Financial Account as well)

Current Account

3 items get listed here
i)Imports
ii) Exports
iii) Transfer Payment

Trade Balance = Diff. of Import of Goods and Export of Goods

Invisible Trade

These are trade in Services and includes
i) Non-factor Services
ii) Incomes (factor and non-factor income + interest, profits, dividend on our assets abroad - of foreign assets in India
iii) Transfer Payments (remittances, Gifts,Grants)[can be both official & private]

Capital Account

all purchases and sales of assets such as money, stock, bonds are listed here.

• FDI
• FII
• direct purchase of assets etc
• External Commercial Borrowings (ECBs)
• External Assistance

BoP deficit is financed through foreign exchange reserve.
India's Foreign exchange reserve is maintained by RBI and consists of 
i) Foreign currencies 
ii) Gold
iii) SDR at IMF

As of 

Foreign Exchange(Forex) Market

A market where national currencies are traded.
Price of one currency in terms of another is exchange rate.
Methods of calculating exchange rate
i) Fixed or Bretton Woods system
 Why did this system broke down? Ans. Speculative Attack
US adopted Floating rate system in 1971. After that most other countries followed suit.
ii) Flexible/Floating Exchange rate
iii) Managed Floating Rate System

Bilateral nominal exchange rate
Bilateral real exchange rate
Multilateral exchange rate such as NEER or REER


If the real exchange rate is 1, then the countries are said to at purchasing power parity
If the real exchange rate is greater than 1, then products at home country have become expensive.
So, real exchange rate is ofter regarded as a measure of country's International Competitiveness

RBI calculates both NEER and REER (REER-6 and REER-36)