Foreign Exchange is required to settle to economic transaction the country has with other
countries. These economic transaction are captured in its balance of payment statement.
A business entity communicates to the outsiders periodically the results of its operations in the form of financial statements such as profits and loss account and balance sheet. These statements summarize the effect of the economic transactions carried out by the entity during the period specified. The economic transactions relate to the exchange of values by the entity with the outsiders.
Residents of country indulge in economic activities with the residents of other countries. These activities include import/export of goods and services, investments made abroad, interest on such investments, etc. These economic transactions have their impact on the domestic economy in the form of addition/depletion of resources, increase/decrease in purchasing power, etc. Consequently, they exert influence over other macro factory like inflation, growth and employment. The monetary and fiscal policies of the government are in turn influenced by these factors. At the national level, it would be useful to compile a statement summarizing all these transactions. In fact every country prepares such a statement known as the Balance of Payments.
Balance of Payments is a record of the value of all transactions between residents of a country with outsiders. It constitutes the result of demand for and supply of foreign exchange for various purposes. Since the forces of demand and supply, balance of payments determine the rate of exchange between currencies is the fundamental factor in determining the exchange rates. A change in the balance of payments of a country will affect the exchange rate of its currency.
Next: Inter-Banks Dealings