The BOP theory of Exchange Rate is a statistical record of all the monetary transaction or payments that takes place between the inhabitants of one country and the rest of the world over a specific time period. The time period is usually one year. According to this theory the demand and supply of a currency depends on the flow of money related to the Balance Of Payments. Balance of payments can be achieved through trades in goods and services, direct investment and portfolio investments. Equilibrium Exchange Rates are determined by the equilibrium in the BOP. In the event of an imbalance in payments the exchange rates will shift to restore the Balance of Payments. In fact, the BOP approach to the Theory of Exchange Rate takes within its purview the theory of PPP.
Every country needs to maintain a balance in their inflow or outflow of money. Conventionally all financial influx is treated as a credit to the Balance Of Payments. A BOP is the term used to denote the cash balance of a country and does not refer to the balance sheet . The BOP is always maintained in tune with the rest of the world. The BOP must equilibrate except for abnormal circumstances like the bankruptcy of a country. Precisely the BOP must be ‘zero’ denoting that equal amount of inflow and outflow has taken place.
Divisions in BOP
The BOP is usually split up in three parts. They are:
- The Capital and Financial Account
- The Current Account
- The Official Reserve AccountThe Capital and Financial Account also referred to as the KA encompasses all the long-term and short-term dealings. It also includes omissions and net errors. Moreover, the financial account deals in all the transactions involving shifts in ownerships of foreign financial assets and liabilities of a particular economy. Whatever transaction is carried on by the Central Bank goes to the official reserve account (OR). These transactions for instance the Federal Bank selling currencies and earning foreign exchange is treated as a credit to the BOP. Ideally the BOP has to be zero and to maintain this there is another item called Statistical Discrepancy (SD). The SD reflects bad transactions that have been omitted. This arises in case of inaccurate recording of transactions.
Therefore the overall Balance of Payment acts to be a good indicator of the pressure that goes into the valuation that is appreciation or depreciation of the currency.
Find out more about Balance of Payment and Exchange Rates.