FOREIGN Exchange Rate and Balance of Payment Questions

and Answers.

Question 1. Differentiate between Balance of Trade and Current Account Balance.

Or
Distinguish between BOT and Balance on current account.

Answer:

Question 2. Should a current account deficit be a cause for alarm? Explain.

Answer: No, if deficit in current account is offset by the capital account, otherwise such
deficit has to be met by following which is a cause for alarm.
1. Depleting Foreign Exchange reserves
2. Taking foreign Loans.
Value: Analytic.

Question 3. If inflation is higher in country A than in country B, and the exchange rate
between the two countries is fixed. What is likely to happen to the trade balance
between the two countries?
Answer: The exports from country B to country A will go up in this situation resulting in
improvement or surplus trade balance for B. But due to higher price in country A, its imports
will increase for country B and it will lead to deficit in trade balance for country A.

I.Very Short Answer Type Questions

Question 1. What does balance of payments account of a country record?

Answer: Balance of payments is an accounting statement that provides a systematic record
of all the economic transactions between the residents of a country and the rest of the world
during a given period of time.
Question 2. What is meant by visible items?
Answer: Visible items include material goods [such as sugar, cloth, machines etc.] which
can be seen or touched, counted, measured and weighted and which are duly recorded at
the custom barriers.
Question 3. What is the meaning of invisible items?
Answer: Invisible items, on the other hand, refer to different kinds of services such as
transport, banking, insurance etc.
Question 4. Why are imports entered as negative items in the balance of payments
account?
Answer: Imports lead to an outflow of foreign exchange in the country. Thus, they are
recorded as negative (debit) items.
Question 5. What is meant by balance of trade?
Answer: The term “balance of trade” denotes the difference between the exports and
imports of goods in a country.
Question 6. Name the items included in balance of trade account.
Answer:
1. Exports of visible items (goods);
2. Imports of visible items (goods).
Question 7. When will balance of trade show a deficit?
Answer: When imports of visible items are more than exports of visible items.
Question 8. How is a deficit or a surplus on the current account restored?
Answer: Deficit on the current account is restored through the surplus on capital account
and surplus on the current account is restored through the deficit on capital account.
II.Short Answer Type Questions
Question 1. State four items of current account of BOP account.
Or
Name the broad categories of transactions recorded in the Current account of the
balance of payment accounts.
Answer: Current account records imports and exports of goods and services and unilateral
transfers.Components of Current Account The main components of Current Account are:
1. Export and Import of Goods (Merchandise Transactions or Visible Trade): A major
part of transactions in foreign trade is in the form of export and import of goods (visible
items). Payment for import of goods is written on the negative side (debit items) and receipt
from exports is shown on the positive side (credit items). Balance of these visible exports
and imports is known as balance of trade (or trade balance).
2. Export and Import of Services (Invisible Trade): It 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. Services are generally of three kinds: (a) Shipping, (b)
Banking, and (c) Insurance. Payments for these services are recorded on the negative side
and receipts on the positive side.
3. Unilateral or Unrequisted Transfers to and from abroad (One sided
Transactions): 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.
4. Income receipts and payments to and from abroad: It includes investment income in
the form of interest, rent and profits.
Question 2. What do you mean by capital account and what are its components?
Or
State four items (components) of capital account of BOP account.
Or
Name the broad categories of transactions recorded in the Capital account of the
balance of payment accounts.
Answer: Capital account is that account which records all such transactions between
residents of a country and rest of the world which cause a change in the asset or liability
status of the residents of a country or its government.Components of Capital Account The
main components of capital account are:
1. Loans: Borrowing and lending of funds are divided into two transactions:
(a) Private Transactions
• These are transactions that are affecting assets or liabilities by individuals, businesses,
etc. and other non-government entities. The bulk of foreign investment is private.
• For example, all transactions relating to borrowings from abroad by private sector and
similarly repayment of loans by foreigners are recorded on the positive (credit) side.
• All transactions of lending to abroad by private sector and similarly repayment of loans to
abroad by private sector is recorded as negative or debit item.
(b) Official Transactions
• Transactions affecting assets and liabilities by the government and its agencies.M
• For example, all transactions relating to borrowings from abroad by government sector
and similarly repayment of loans by foreign government are recorded on the positive (credit)
side.
• All transactions of lending to abroad by government sector and similarly repayment of
loans to abroad by government sector is recorded as negative or debit item.
2. Foreign Investment (Investments to and from abroad) It includes:
(a) 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.
(b) Investments by Indian residents in shares of foreign companies, real estate abroad, etc.
Such investments to abroad are recorded on the negative (debit) side as they lead to
outflow of foreign exchange.
3. Change in Foreign Exchange Reserves
(a) The foreign exchange reserves are. the financial assets of the government held in
central bank. A change in reserves serves as the financing item in India’s BOP.
(b) So, any withdrawal from the reserves is recorded on the positive (credit) side and any
addition to these reserves is recorded on the negative (debit) side.
(c) It must be noted that ‘change in reserves’ is recorded in the BOP account and not
‘reserves’.
Question 3. Distinguish between current account and capital account of BOP
account.
answer:

Question 4. Distinguish between balance of trade and balance of payment.

Answer:

Question 5. Distinguish between autonomous and accommodating transactions of

BOP account. ”

Answer:
Question 6. Where is ‘borrowings from abroad’ recorded in the Balance of Payments
Accounts? Give reasons.
Answer:
1. Borrowing from abroad is a part of Capital Account.
2. Borrowing from abroad can be private transactions or official transactions.
3. For example,
(a) All transactions relating to borrowings from abroad by private sector are recorded on the
positive (credit) side as it is inflow of foreign currency.
(b) Similarly, transactions relating to borrowings from abroad by government sector are
recorded on the positive (credit) side as it is inflow of foreign currency.
Question 7. Where will sale of machinery to abroad be recorded in the balance of
payment accounts? Give reasons.
Answer:
1. Sale of machinery to abroad is a part of Current accounts.
2. Current account records imports and exports of goods and services and unilateral
transfers.
3. Sale of machinery to abroad leads to inflow of foreign currency and receipt from exports
is shown on the positive side (credit items).
Question 8. What is meant by ‘official reserve transactions’? Discuss their
importance in Balance of Payments.
Answer:
1. Official reserve transactions are those transactions by a central bank that cause changes
in its official reserves.
2. It is sale or purchase of its own currency in the exchange market in exchange for foreign
currencies.
3. So, any withdrawal from the reserves is recorded on the positive (Credit) side and any
addition to these reserves is recorded on the negative (debit) side.
4. They may be Autonomous and Accommodating Transactions.
lll. True Or False
Question 1. In balance of payments, repayment of loans by Indian Government to
American Government will be reflected as debit item.
Answer: True. It is so because it leads to outflow of foreign exchange.
Question 2. Accommodating items of trade are undertaken in order to maintain the
balance in the BOP account.
Answer: True. Accommodating transactions are net consequences of autonomous
transactions that are undertaken to correct disequilibrium in autonomous items of BOP.
Question 3. Excess of foreign exchange payments on account of accommodating
transactions equals deficit in BOP.
Answer: False. Excess of foreign exchange payments on account of autonomous
transactions equals deficit in BOP.
Question 4. Export and import of machines are recorded in capital account of BOP
account.
Answer: False. Export and import of machines are considered as export and import of
goods, that comes under current account of BOP account.
Question 5. Foreign exchange received on account of export of sugar will be
X’ecorded in current account.
Answer: True. It is so because export of sugar is a export of goods which is a component of
current account.
Question 6. Accommodating items are also known as ‘above the line’ items.
Answer: False. Accommodating items are also known as ‘below the line’ items.
(Autonomous items are also known as ‘above the line’ items.)
Question 7. Unilateral transfers received from abroad will be recorded as a credit
item of BOP on current account.
Answer: True. It leads to inflow of foreign exchange.
Question 8. Borrowing by government from World Bank to finance the BOP deficit
will be recorded in the capital account.
Answer: True. Borrowing by the government is a accommodating transaction and it is
recorded in the capital account only.
Question 9. Autonomous transactions take place in current account only.
Answer. False. Autonomous transactions take place in both current and capital accounts.
EXTRA QUESTIONS ANSWERS

Giving reasons explain why charity to foreign countries is recorded in the

Balance of Payments Accounts.
Answer:
Charity to foreign countries is unilateral transfers, which are a part of BoP’s current
account. These transfers are one-sided and cause an outflow of foreign currency. Thus,
charity to foreign countries will be recorded as negative item in the current account of
Balance of Payments.

2 State four sources each of demand and supply of foreign exchange. (C.B.S.E 2010)
Answer:
Following are the four sources each of demand for and supply of the foreign exchange:

Sources of Demand for Foreign Exchange

● Purchase of goods and services from other countries

● Send gift abroad
● Purchase of financial assets in a particular country
● Speculative trading on the value of the foreign currencies

Sources of Supply of Foreign Exchange

● Foreigners purchasing home country’s goods and services through exports

● Foreign investment in home country through joint ventures
● Foreign investment in heme country through the financial market operations
● Foreign currencies flow into the economy through the currency dealers and
speculators
Question 3.
How is foreign exchange rate determined? Use diagram. (C.B.S.E. Outside Delhi 2013)
Or
Discuss briefly the concept of flexible exchange rate system of foreign exchange rate
determination. (C.B.S.E. Outside Delhi 2019)
Answer:
The exchange: rate in the foreign market is determined:by the intersection; of supply
and demand, curves of the foreign exchange .The foreign exchange market, like any
other normal market, comprises of a downward sloping demand curve and an upward
sloping supply curve.
In the following diagram, the vertical shows

He states in terms of the domestic currency, Cruf is,” amount of rupee for one US
dollar, The horizontal axis measures the quantity demanded or supped. At point E, the
intersection of demand and supply curves determines the equilibrium exchange rate in
the foreign market (R*) and equilibrium quantity (Q*) of the foreign currency, that is, US
dollar ($).

An increase in the demand for US dollars in India will cause the demand curve to shift to
D’$ and the exchange rate rises to R’. Similarly, an increase in the supply of US dollars
will cause the supply curve shift to S’$ and the exchange rate falls to RT In this: case,
the domestic currency is more valuable.

Question 4.
Explain the impact of rise in exchange rate on national income. (C.8.S.E 2018)
Answer:
A rise in the foreign exchange rate implies that the price of foreign currency, in terms of
domestic currency, has increased. Since domestic goods and services have become
cheaper, the foreign country can now buy higher quantity from one unit of its currency.
This will result in increased demand for Indian exports. Moreover, depreciation of
domestic currency will make the imports from foreign countries more expensive. Thus,
there will be increase in exports and fall in imports, causing the net exports to rise.
Consequently, the net aggregate demand for domestically produced goods will increase
and so will the national income.

Question 5.
When exchange rate of foreign currency rises, its supply rises. How? Explain. (C.B.S.E
2011)
Answer:
The foreign exchange rate is the price of one currency in terms of another currency. A
rise in the foreign exchange rate implies that the price of foreign currency, in terms of
domestic currency, has increased. Since domestic goods and services have become
cheaper, the foreign country can now buy higher quantity from one unit of its currency.
This increases the supply of foreign currency in the domestic country.

For instance, suppose the foreign exchange rate between India and UK has increased.
The price of one pound has increased from ₹ 60 to ₹ 70. It implies that UK citizens can
buy ₹ 70 worth of goods by parting one pound compared to only ₹ 60 worth of goods
prior to rise in exchange rate. Since Indian goods have become cheaper for UK, they
will buy more of them. This increases the supply of UK pounds to India. Thus, a rise in
foreign exchange rate causes a rise in its supply.

Question 6.
When exchange rate of foreign currency fells its demand rises. Explain how?

The foreign exchange rate is the price of one currency in terms of another currency. A fall in the
foreign exchange rate implies that the price of foreign currency, in terms of domestic currency,
has l decreased. Since foreign goods and services have become cheaper, the domestic country
can now buy higher quantity.

This increases the demand for foreign currency in the domestic country. : For instance,
suppose the foreign exchange rate between India and UK has decreased. The price of
one pound has fallen from ₹ 70 to ₹ 60. It implies that Indians have to pay only ₹ 60 to
buy one pound worth: of goods compared to ₹ 70 prior to fell in exchange rate. Since
goods in UK have become cheaper for; India, Indians will buy more of them. This
increases the demand for UK pounds in India Thus, a fall in foreign exchange rate
causes a rise in its demand :

Question 7.
Give two reasons for a rise in demand for a foreign currency when its price fells.
Answer:
Following are the two reasons for the rise in the demand for a foreign currency when its
price falls:
(i) When the price of a foreign currency falls, the imports from that country become
cheaper. As a result, imports increase, and hence, the demand for the foreign currency
also rises.

(ii) When a foreign currency becomes cheaper in terms of domestic currency, people
plan investment in foreign country. As a result, demand for that foreign currency rises.

Question 8.
State any two merits and demerits of flexible exchange rate system:
Answer:
Merits of Flexible Exchange Rate System
(i) Flexible exchange rate system automatically corrects the deficit or surplus in the
Balance of Payments account.
(ii) The government is not required to hold any foreign exchange reserves.

Demerits of Flexible Exchange Rate System

(i) It encourages speculation in the foreign exchange market.
(ii) There can be wide fluctuations in exchange rate, which may cause instability in the
foreign trade.

Question 9.
Explain two merits each of fixed foreign exchange rate.
Answer:
Merits of Fixed Exchange Rate System
(i) Fixed exchange rate system ensures stability in foreign exchange market.
(ii) It prevents speculative activities in foreign exchange market.

Question 10.
There is an inverse relation between foreign exchange rate and demand for foreign
exchange.Why? Explain.
Answer:
There is an inverse relationship between demand for foreign exchange and rate of
exchange.
The curve showing demand for the foreign exchange (DD) slopes downward from left to
right. This implies that higher the exchange rate, lower would be the demand for foreign
exchange, and vice-versa. The diagram shows that when the exchange rate is OR then
the demand for foreign exchange is OQ. However, when the exchange rate declines to
OR’, then the demand for foreign exchange increases to OQ’.

Question 11.Explain the meaning of managed flexible exchange rate.

Or
Discuss briefly the concept of managed floating system of foreign exchange rate
determination. (C.B.S.E Outside Delhi 2019)
Answer:
Managed flexible foreign exchange rate is a system, which allows adjustments in
exchange rate according to a set of rules and regulations officially declared in the
foreign exchange market. There is no pre-defined range and time for the adjustment.
Adjustment is allowed entirely on the merits of a care. It is for the managing authority to
allow or reject the appeal for adjustment.

Question 12
When price of a foreign currency rises, its demand falls. Explain why? (C.B.S.E Comp.
2011,2012)
Answer:
The foreign exchange rate is the price of one currency in terms of another currency. A
rise in the foreign exchange rate implies that the price of foreign currency, in terms of
domestic currency, has increased. Since foreign goods and services have become
expensive, the domestic country can now buy less of them.

This decreases the demand for foreign currency in the domestic country. For instance,
suppose the foreign exchange rate between India and UK has increased. The price of
one pound has increased from ₹ 70 to ₹ 80. It implies that Indians have to pay ₹ 80 to
buy one pound worth of goods compared to ₹ 70 prior to rise in exchange rate.
Since goods in UK have become expensive for India, Indians will buy less of them. This
decreases the demand for UK pounds in India. Thus, a rise in foreign exchange rate
causes a fall in its demand.

Question 13.
When price of a foreign currency falls, the supply of that foreign currency also falls.
Explain why? (C.B.S.E Outside Delhi 2011)
Answer:
The foreign exchange rate is the price of one currency in terms of another currency. A
fall in the foreign exchange rate implies that the price of foreign currency, in terms of
domestic currency, has decreased. Since domestic goods and services have become
expensive, the foreign country can now buy lesser quantity from one unit of its currency.
This decreases the supply of foreign currency in the domestic country.

For instance, suppose the foreign exchange rate between India and UK has decreased.
The price of one pound has decreased from ₹ 60 to ₹ 50. It implies that UK citizens can
buy only ₹ 50 worth of goods by parting one pound compared to only ₹ 60 worth of
goods prior to fall in exchange rate. Since Indian goods have become expensive for UK
citizens, they will buy less of them. This decreases the supply of UK pounds to India.
Thus, a fall in foreign exchange rate causes a fall in its supply.

Question 14.Explain the effect of appreciation of domestic currency on imports.

(C.B.S.E 2013)
Answer:
Appreciation of a currency means an increase in the value of the domestic currency in
terms of the foreign currency. The price of the domestic currency, in terms of a foreign
currency, increases and the foreign exchange rate decreases. For instance, suppose
rupee has appreciated in terms of pound.

That is, the foreign exchange rate between India and UK has decreased. The price of
one pound has decreased from ₹ 70 to ₹ 60. It implies that Indian citizens can buy one
pound worth of goods by parting only ₹ 60 compared to ₹ 70 priorto fall in exchange
rate. Since UK goods have become cheaper for Indians, they will buy more of them.
Consequently, Indian imports from UK will increase.

Question 15
Explain the effect of depreciation of domestic currency on exports. (C.B.S.E Outside
Delhi 2013)
Answer:
Depreciation of a currency means a decrease in the value of the domestic currency in
terms of the foreign currency. The price of the domestic currency, in terms of a foreign
currency, decreases and the foreign exchange rate increases. For instance, suppose
rupee has depreciated in terms of pound.
That is, the foreign exchange rate between India and UK has increased. The price of
one pound has increased from ₹ 60 to ₹ 70. It implies that UK citizens can buy ₹ 70
worth of goods by parting one pound compared to only ₹ 60 worth of goods prior to rise
in exchange rate. Since Indian goods have become cheaper for UK, they will buy more
of them. Consequently, Indian exports to UK will increase.

Question 16.
“Indian Rupee (₹) plunged to all time low of ₹ 74.48 against the US Dollar ($)”.
In the light of the above report, discuss the impact of the situation on Indian Imports.
(C.B.S.E 2019)
Answer:
Indian rupee plunged to all time low of rupees ₹ 74.4 8 against US Dollar. This is called
as depreciation in the value of Indian rupee. It might lead to fall in imports as foreign
goods will become more expensive for domestic consumers.

Question 17.
Recently Government of India has doubled the import duty on gold.What impact is it
likely to have on foreign exchange rate and how? (C.B.S.E 2014)
Answer:
When the import duty on gold rises, the import of gold would become costlier. This
would reduce
the demand for foreign currency. Since the supply of foreign currency remains the
same, the foreign exchange rate would fall. This implies appreciation of rupees.

In the diagram, point E determines the equilibrium exchange rate in the foreign market
(R*) and equilibrium quantity (Q*) of the foreign currency, where demand (DD) and
supply (SS) curves intersect. A fall in the demand for foreign currency will cause the
demand curve to shift-to the left from DD to D1D1, and the exchange rate falls to R1 New
equilibrium is established at E1.

Question 18
Distinguish between appreciation of home currency and depreciation of home currency.
(C.B.S.E Outside Delhi 2019)
Answer:
Appreciation of home currency means increase in the value of the domestic currency in
terms of the currencies of the other countries. On the other hand, depreciation of home
currency means lowering of the value of the domestic currency in terms of the
currencies of the other countries.

Question 19.
Explain the effect of appreciation of domestic currency on exports. (C.B.S.E Outside
Delhi 2014)
Answer:
Appreciation of a currency means an increase in the value of the domestic currency in
terms of the foreign currency. The price of the domestic currency, in terms of a foreign
currency, increases and the foreign exchange rate decreases. For instance, suppose
rupee has appreciated in terms of pound.

That is, the foreign exchange rate between India and UK has decreased. The price of
one pound has decreased from ₹ 70 to ₹ 60. UK citizens can buy only 60 worth of
goods by parting one pound compared to X 70 worth of goods prior to fall in exchange
rate. Since Indian goods have become expensive for UK citizens, they will buy less of
them. Consequently, Indian exports to UK will decrease.

Question 20.
How does giving incentives for exports influence foreign exchange rate? Explain.
(C.B.S.E 2014)
Answer:
The incentives for exports boost exports of the country. An increase in exports causes
the supply of foreign currency to increase in the domestic country while the demand
remains unchanged. Consequently, the exchange rate falls and the domestic currency
appreciates. in the diagram, point E determines the equilibrium exchange rate in the
foreign market (R*) and equilibrium quantity (0*) of the foreign currency, where demand
(DD) and supply (SS) curves intersect. A rise in the supply for foreign currency will
cause the supply curve to shift to the right from SS to S1 S1 and the exchange rate falls
to R1.

Question 21.
Vista to foreign countries for sight seeing etc by the people of India in the rise. What will
be its impact on foreign exchange rate? How?
Answer:
Increase in the foreign visits of Indian residents would increase the demand for foreign
currency increases. Since the supply of foreign currency remains the same, the foreign
exchange rate would rise implying depreciation of rupee.

In the diagram, point E determines the equilibrium exchange rate in the foreign market
(R*) and equilibrium quantity (Q*) of the foreign currency, where demand (DD) and
supply (SS) curves intersect. A rise in the demand for foreign currency will cause the
demand curve to shift to the right from DD to D1D1 and the exchange rate rises to R1.
Open Economy Macroeconomics Important Extra Questions Long Answer
Type
Question 1.
Explain the causes of disequilibrium in the Balance of Payments.
Answer:
Following are the causes of disequilibrium in Balance of Payments:

1. Natural Causes
Natural calamities like famine, flood, etc. may cause disequilibrium in the Balance of
Payments of an economy as these calamities result in reduction in production and
exports and increase in imports.

2. Economic Causes
(i) Economic Development: In order to accelerate the pace of development,
underdeveloped countries have to depend on foreign assistance. These countries
import advanced machinery, capital goods and raw material, etc, which results in the
excess of imports over exports. Flence, there arises the problem of disequilibrium in
Balance of Payments.

(ii) Cyclical Fluctuations: Cyclical fluctuations like inflation and depression also cause
the problem of disequilibrium of Balance of Payments. If there is depression in the world
market then exports of a country are affected adversely. Similarly, if prices start rising
within the economy, the rate of increase in imports exceeds that of exports, which
results in disequilibrium.

(iii) Capital Outflow: If a country invests its capital in other countries in order to earn
more dividend then it may result in unfavourable Balance of Payments of the country
investing the capital and favourable Balance of Payments of the country where the
capital is invested. Hence, the problem of disequilibrium arises.

3. Political Factors
Government expenditure in foreign countries, political instability, political relations with
other countries partition or unification of a country etc. may cause disequilibnum in
Balance of Payments of a country.

Question 2.
What do you mean by Balance of Payment? Explain the items constituting the Balance
of Payments of country.
Answer:
Balance of Payments (BoP) records the transactions in goods, services and assets of
the residents of a country with the rest of the world. It also records the country’s
demand for and supply of foreign ex-change.
Items of Current Account

(i) Export and Import of Goods: Current account shows exports and imports of visible
items i.e., goods like machinery, wheat, steel, etc.

(ii) Export and Import of Services: Current account shows exports and imports of
invisible items i.e., services like banking, tourism, insurance, etc.

(iii) Unilateral Transfers: These are those receipts, which residents of a country receive
or payments that the residents of a country make without getting anything in return.
Receipts from abroad are entered as positive items and payments abroad are entered
as negative items.

(iv) Private Transfers: These are gifts that domestic residents receive from or make to
foreign residents.

Items of Capital Account

● Private Transactions: These are transactions that affect the assets or liabilities of
individuals, business, etc. and other non-government entities.
● Official Transactions: These are the transactions that affect the assets and liabilities by
the government and its agencies.
● Direct Investment: Direct investment means the act of purchasing an asset and at the
same time acquiring control of it.
● Portfolio Investment: It is the acquisition of an asset that does not give the purchase
control over the asset.

Question 3.
What is foreign exchange rate? Explain how it is determined.
Answer:
Foreign exchange rate is the price of one unit of the foreign currency in terms of the
domestic currency.
Determination of Foreign Exchange Rate: Foreign Exchange Rate is determined in the
exchange
market at the point of intersection of foreign exchange demand and supply curves.

1. Demand Curve of Foreign Exchange: A country is dependent upon other countries for
its requirements of imports and foreign capital. Demand for foreign exchange arises to
make payments for these imports. There is an inverse relationship between the demand
for foreign exchange and the rate of exchange. If the exchange rate increases, the
demand for foreign exchange would fall and the vice-versa.

In the diagram, demand for foreign exchange is OD when exchange rate is OR. When
the rate of exchange falls to OR, then demand for foreign exchange increases to OD,.
Demand curve for foreign exchange (DD) curve slopes downwards from left to right.

2. Supply Curve of Foreign Exchange: Supply of foreign exchange depends on a

number of factors like the value of exports of a country, import of capital, extent of
foreign investment, etc. There is direct relation between exchange rate and the supply
of foreign exchange. An increase in the exchange rate results in an increase in the
supply of foreign exchange and vice-versa.

In the diagram, the supply of foreign exchange is OS when exchange rate is equal to
OR. If the exchange rate is increased to OR,, supply of capital also increases to OS,.
SS is the positively sloped supply curve of foreign exchange.
3. Equilibrium Foreign Exchange Rate: Equilibrium exchange rate is determined at a
level where demand for foreign exchange is equal to supply of foreign exchange. The
determination of equilibrium foreign exchange rate can be explained with the help of
given diagram:

The demand for foreign exchange is equal to supply of foreign exchange at point E. the
equilibrium foreign exchange rate is OR and equilibrium quantity of foreign exchange is
OQ. MN represents excess demand for foreign exchange at OR,. Similarly, KL
represents excess supply of foreign exchange at OR2.

Question 4.
Give arguments in favour and against the fixed and flexible
Answer:
Arguments in Favour of Fixed Exchange Rate

1. Encouragement to Foreign Trade: The system of fixed exchange rate provides

suitable environment for foreign trade. The exporters and the importers have no fear of
changes in the prices of goods and it helps to promote the foreign trade.

2. End to Speculations: There is no uncertainty in the foreign exchange market under

the system of fixed exchange rate. It helps to bring an end to the activities of
speculation as a result of uncertainty.

3. Internal Stability: Fixed exchange rate results in internal economic stability of a

country. The fluctuations in the price level are reduced to the minimum on account of
stability of exchange rate and the prices of imports and exports.

4. Useful for Small Countries: For the small countries like Denmark, Belgium, etc. this
system of exchange rate has turned out to be very useful. For the countries dependent
on foreign trade for their economic development, stability of exchange rate is essential.
Flexibility in rate of exchange may adversely affect the process of economic
development of these countries.

Arguments against Fixed Rate of Exchange

1. Monetary Dependence: If the exchange rate is fixed then the unfavourable Balance of
Payments of a country has an adverse effect on the level of domestic output and
income. Under such a situation, the government of a country will have to adopt such a
monetary policy, which does not influence its exchange rate. Thus, the government is
not free to formulate an independent monetary policy.

2. Cost-price Relationship: The fixed exchange rate is not determined in accordance

with the value theory of price determination. Since economic policies of different
countries are not alike, their cost-price relationships do not remain stable. Thus, fixed
exchange rate does not enable us to analyse the changes in cost-price relations and
their effect on exchange rate.

3. Increase in Demand for Foreign Exchange: The demand forforeign exchange in a

country increases under the system of fixed exchange rate. Therefore, the government
will have to accumulate the stock of foreign exchange and consequently, will have to
bear the opportunity cost of foreign exchange.

4. Slow Rate of Growth: There is lack of co-ordination among the economic policies of
different countries under the system of fixed exchange rate. As a result a country fails to
achieve the desired rate of growth in the absence of co-ordination and co-operation of
other countries.

Arguments in Favour of Flexible Exchange Rate

1. Solves the Problem of BoP Deficit: The flexible exchange rate helps to solve the
problem of BoP deficit of a country. For example, if demand for foreign exchange
exceeds its supply, the rate of exchange will increase to attain equilibrium. On the other
hand, if supply of foreign exchange exceeds its demand, the rate of exchange will
decrease to attain equilibrium.

2. Effective Monetary Policy: According to Prof. Friedman, monetary policy of a country

can be effectively implemented if its exchange rate is flexible. If the objective of
monetary policy is to increase the level of production then rate of interest will be
reduced to provide incentive for investment. It will also result in an increase in the level
of output and hence the exports.

3. Regulations of Import and Export: The level of production, income and employment
keep on changing in an economy. These changes influence the demand for and supply
of goods. Keeping in view the demand and supply of goods, the government of a
country may introduce changes in its imports and exports, which are possible only
under the system of flexible exchange rate.

Arguments against Flexible Exchange Rate

1. Effect on Economic Structure: The economic activities of international market have a

direct impact on the structure of an economy if the exchange rate is flexible. The
fluctuations in international market influence the price level, level of output and
employment of an economy.

2. Uncertainty: Flexible exchange rate creates an environment of uncertainty in the

international market, which in turn adversely affects the flow of capital among the
countries. Moreover, it hinders the process of borrowing and lending of loans in the
international market.

3. Internal Instability: The system of flexible exchange rate, sometimes, results in the
problem of internal instability in a country if the assumptions of full employment, perfect
competition and perfect mobility of factors of production are not fulfilled.

4. Unnecessary Capital Movements: Under the system of flexible exchange rate, capital
movements among the countries may increase unnecessarily. Such capital movements
may prove to be harmful for the structure of an economy.

Question 5.
Give the meaning of‘foreign exchange and foreign exchange rate’. Giving reason
explain the relation between foreign exchange rate and demand for foreign exchange.
Answer:
Foreign Exchange: Foreign exchange is the conversion of one currency into another
currency.

Foreign Exchange Rate: Foreign exchange rate is the price of one currency in terms of
another currency.
Relation between Foreign Exchange Rate and Demand for Foreign Exchange There is
an inverse relation between foreign exchange rate and demand for foreign exchange.
The relationship can be explained with the help of a diagram.

In the diagram, X axis shows the quantity of foreign exchange demanded and Y axis
shows the price of foreign exchange. The curve showing demand for the foreign
exchange (DD) slopes downward from left to right. This implies that higher the
exchange rate, lower would be the demand for foreign exchange, and vice-versa. The
diagram shows that when the exchange rate is OR then the demand for foreign
exchange is OQ.

When the exchange rate declines to OR’, foreign goods become cheaper than the
domestic goods. Thus, the demand for foreign exchange increases to OQ’. On the
contrary, when the exchange rate increases to OR’, foreign goods become expensive
than the domestic goods. Thus, the demand for foreign exchange decreases to OQ’.

Question 6.
Why does the demand for foreign currency fall and supply rises when its price rises ?
Explain. (C.B.S.E. 2017)
Answer:
When the price of the foreign currency increases, the value of domestic currency
increases in terms of the foreign currency. In other words, we can say that the domestic
currency depreciates.

Now in such a case, there are two implications.

(a) Since the domestic currency has depreciated the imports become expensive. The
domestic traders will have to pay more to buy the same units of foreign good. This leads
to a decline in the demand for the foreign currency.
(b) At the same time, with a depreciation in the domestic currency, the exports become
cheaper. This will bring in more foreign currency hence, leading to an increase in the
foreign exchange supply.

Open Economy Macroeconomics Important Extra Questions HOTS

Question 1.
The balance of trade shows a deficit of ₹ 5,000 crores and the value of imports are ₹
9,000 crores. What is the value of exports?
Answer:
The balance of trade is the difference between the value of exports (X) and the value of
imports (M).
That is, Balance of Trade – Value of Exports – Value of Imports
Given: Balance of Trade = (-) ₹ 5,000 crores
Value of Imports = ₹ 9,000 crores
Thus, 5000 = Value of Exports – 9000
Value of Exports = – 5000 + 9000 = 4000
The value of exports is ₹ 4,000 crores.

Question 2.
The balance of trade shows a deficit of ₹ 300 crores.The value of exports are ₹ 500
crores. What is the value of imports?
Answer:
The balance of trade is the difference between the value of exports (X) and the value of
imports (M).
That is, Balance of Trade = Value of Exports – Value of Imports
Given: Balance of Trade = (-) ₹ 300 crores
Value of Exports = ₹ 500 crores
Thus,
– 300 = 500 – Value of Imports Value of Imports = 500 + 300 = 800
The value of imports is ? 800 crores.

Question 3.
Name three such items which are not included in the balance of trade.
Answer:
Items which are not included in the balance of trade are:

● Exports and imports of services such as of shipping and banking, etc.

● Interest and dividend payments between the countries.
● Expenditure by the tourists.

Question 4.
Why is flexible rate of exchange called free rate of exchange?
Answer:
Flexible rate of exchange is called free rate of exchange as it is freely determined by the
forces of supply and demand in the international money market.