CBSE Class 12 Economics Balance of Payment and Foreign Exchange Rate Assignment

Question. In case of currency appreciation, the domestic currency becomes …… .
(a) less valuable
(b) more valuable
(c) rise
(d) fall

Answer. B

Question. Which items in balance of payments are also called ‘above the line’ items?
(a) Autonomous items
(b) Accommodating items
(c) Visible items
(d) Invisible items

Answer. A

Question. Which of the following international agency manage foreign exchange rate system in the world?
(a) Central Bank
(b) IMF
(c) World Bank
(d) All of these

Answer. B

Question. Buying and selling of foreign currencies take place at
(a) goods market
(b) gold market
(c) foreign exchange market
(d) All of these

Answer. C

Question. Who will be benefited when there is a appreciation in a foreign currency in terms of domestic currency?
(a) Importers
(b) Exporters
(c) Both (a) and (b)
(d) Neither (a) nor (b)

Answer. B

Question. Other things remaining unchanged, when in a country the price of foreign currency rises, national income is …… .
(a) likely to rise
(b) likely to fall
(c) Both (a) and (b)
(d) not affected

Answer. A

Question. Under which of the following exchange rate system, exchange rate was determined and fixed by Central Bank of a country and changes can be made by the Central Bank only.
(a) Gold standard
(b) Bretton woods
(c) Floating
(d) Both (a) and (b)

Answer. D

Question. Other things remaining the same, when in a country the market price of foreign currency falls, national income is likely …... .
(a) to rise
(b) to fall
(c) Both (a) and (b)
(d) to remain unaffected

Answer. B

Question. Choose the correct statement from given below
(a) Balance of trade is a component of capital account of balance of payments.
(b) Floating exchange rate is used to stabilise price of foreign currency.
(c) Increase in the supply of foreign exchange rate leads to fall in its price.
(d) Rise in exchange rate leads to revaluation of currency.

Answer. C

Question. Choose the correct statement from given below
(a) Balance of trade records the exports and imports of invisible items.
(b) A surplus in BoT can rectify the deficit in BoP.
(c) Accommodating items are only recorded in capital account of BoP.
(d) Import of machinery will be recorded in capital account of BoP.

Answer. C

Question. Balance of payments deficit is calculated by taking into account the …… only.
(a) accommodating transactions
(b) autonomous transactions
(c) unilateral transactions
(d) None of these

Answer. B

Question. …… is the rate which is determined by market forces.
(a) Fixed exchange rate
(b) Real exchange rate
(c) Flexible exchange rate
(d) Nominal exchange rate

Answer. C

Question. Unilateral transfers are included in
(a) current account BoP
(b) capital account BoP
(c) Both (a) and (b)
(d) None of these

Answer. A

Question. How will a banking crisis in domestic country affects demand curve for foreign exchange?
(a) Demand for foreign exchange will shift to the right
(b) Demand for foreign exchange will shift to the left
(c) There will be downward movement along demand curve
(d) There will upward movement along demand curve

Answer. A

Question. What is the difference between the value of exports and value of imports of goods called?
(a) Balance of Payments
(b) Foreign exchange
(c) Balance of Trade
(d) Disequilibrium

Answer. C

Question. Foreign exchange transactions dependent on other foreign exchange transactions are called
(a) current account transactions
(b) capital account transactions
(c) autonomous transactions
(d) accommodating transactions

Answer. D

Question. Which is not a feature of Balance of Payments (BoP) Account?
(a) It includes economic transactions
(b) It has given period of time
(c) It records only capital transactions
(d) Trade between resident of a country and rest of the world

Answer. C

Question. Which items are excluded in BoT, but included in BoP?
(a) Visible items
(b) Invisible items
(c) Private capital
(d) Both (b) and (c)

Answer. D

Question. If the value of exports is Rs 200 and value of imports is Rs 250, there will be
(a) Trade surplus of Rs 50
(b) Trade deficit of Rs 50
(c) Trade balance
(d) None of these

Answer. B

Question. Which is not a part of income receipts and payments from/to abroad in BoP account?
(a) Profits
(b) Grants
(c) Interest
(d) Dividends

Answer. B

Question. Government transactions include …… to keep the BoP in balance and which are not carried out forprofits.
(a) borrowings from IMF and other financial institutions
(b) grants and donations
(c) foreign exchange reserve
(d) Both (a) and (c)

Answer. D

Question. Choose the incorrect statement from given below
(a) Repayment of loan taken from IMF will be recorded on debit side.
(b) Surplus in BoP refers to a state where debit side exceeds credit side.
(c) Increase in investment from rest of the world decreases the exchange rate.
(d) Devaluation of current items improves trade balance of domestic country.

Answer. B

Question. …… involves transactions related to transfers of assets and liabilities in BoP account.
(a) Balance of trade account
(b) Current account
(c) Unilateral transfer account
(d) Capital account

Answer. D

Question. What will be the impact on trade deficit if exchange rate rises?
(a) Increase
(b) Decrease
(c) Remain constant
(d) Depends upon rate of change

Answer. A

Question. Foreign exchange transactions which are independent of other transactions in the balance of payments account are called
(a) current transactions
(b) capital transactions
(c) autonomous transactions
(d) accommodating transactions

Answer. C

Question. What will be the impact on aggregate demand in an open economic model, if there is decrease in foreign exchange rate?
(a) Increase
(b) Decrease
(c) Remain constant
(d) Depends upon the purchasing power parity

Answer. B

Question. During the currency crisis, the foreign exchange reserve with Central Bank will
(a) increase
(b) decrease
(c) remain constant
(d) None of these

Answer. B

Question. A company located in India receives a loan from a company located abroad. How is this transaction recorded in India’s balance of payments account?
(a) Credit side of current account
(b) Debit side of capital account
(c) Debit side of current account
(d) Credit side of capital account

Answer. D

Foreign exchange rate refers to the rate at which one unit of currency of a country can be exchanged for the number of units of currency of another country.

SYSTEM OF EXCHANGE RATE:
1. Fixed exchange rate
2. Flexible exchange rate. In fixed exchange rate system, the rate of exchange is officially fixed or determined by Government or Monetary Authority of the country.

Merits of Fixed Exchange Rate
➢ Stability in exchange rate
➢ Promotes capital movement and international trade.
➢ It forces the govt. to keep inflation in check. Demerits of Fixed Exchange Rate
➢ Need to hold foreign exchange reserves.
➢ No automatic adjustment in the ‘Balance of payments.’
➢ It may result in undervaluation or overvaluation of currency.

In a system of flexible exchange rate (also known as floating exchange rates), the exchange rate is determined by the forces of market demand and supply of foreign exchange.
The demand of foreign exchange has the inverse relation with flexible exchange rate. If flexible exchange rate rise the demand of foreign exchange falls. Vice versa.

Sources of Demand for Foreign Exchange
➢ To purchase goods and services from the rest of world.
➢ To purchase financial assets (i.e.., to invest in bonds and equity shares) in a foreign country.
➢ To invest directly in shops, factories, buildings in foreign countries.
➢ To send gifts and grants to abroad.
➢ To undertake foreign tours.

The supply of foreign exchange has the positive relation with foreign exchange rate.
If foreign exchange rate rises the supply of foreign exchange also rises and vice versa.

Sources of Supply of Foreign Exchange
➢ Direct purchase by foreigners in domestic market.
➢ Direct investment by foreigners in domestic market.
➢ Remittances by non-residents living abroad.
➢ Exports of goods and services.

Merits of Flexible Exchange Rate
➢ No need to hold foreign exchange reserves
➢ Leads to automatic adjustment in the ‘balance of payments.
➢ To enhances efficiency in resources allocation. Demerits of Flexible Exchange Rate
➢ Fluctuations in future exchange rate.
➢ Encourages speculation.
➢ Discourages international trade and investment.

Determination of Equilibrium Foreign Exchange Rate:
o Equilibrium FER is the rate at which demand for and supply of foreign exchange is equal.
o Under free market situation, it is determined by market forces i.e., demand for and supply of foreign exchange.
o There is inverse relation between demand for foreign exchange and exchange rate.
o There is direct relationship b/w supply of foreign exchange and exchange rate.
o Due to above reasons demand curve downward sloping and supply curve is upward sloping curve Graphically intersection of demand Curve and supply curve determines the equilibrium foreign exchange rate.

❖ Devaluation of a currency: When government or monetary authority of a country officially lowers the external value of its domestic currency (in respect of all other foreign currency) is called devaluation of a currency. It takes place by government order under fixed exchange rate system.
❖ Revaluation of a currency: When government or monetary authority of a country officially raises the external value of its domestic currency is called revaluation. It takes place by government order under fixed exchange rates system.
❖ In currency depreciation there is a fall in the value of domestic currency, in term of foreign currency due to change in demand and supply of the currency under flexible exchange rate system.
❖ In currency appreciation, there is a rise in the value of domestic currency in terms of foreign currency due to change in demand and supply of the currency under flexible exchange rate system.
❖ Managed floating regime is an international financial environment in which exchange rates fluctuate from day to day, but central banks attempt to influence their countries' exchange rates by buying and selling currencies to maintain a certain range.
When central bank finds the rate is too high, it starts selling foreign exchange from its reserve to bring down it. When it finds the rate is too low. It starts buying to raise the The peg used is known as a crawling peg.

Multiple Choice Questions

Question. Other things remaining the same, when in a country the market price of foreign currency rises, national income is likely ........................
a) to rise
b) to fall
c) to rise or to fall
d) to remain unaffected
Answer. B

Question. Which exchange rate is officially declared by the government?
a) Managed floating rate
b) Floating exchange rate
c) Fixed exchange rate
d) None of these
Answer. C

Question. Investments by large multinational corporations (MNCs) in India will ensure greater inflow of foreign exchange, leading to an increase in the ...........................
a) Supply of foreign currency
b) Supply of domestic currency
c) Demand for foreign currency
d) Demand for domestic currency
Answer. A

Question. Depreciation of domestic currency leads to rise in exports.
a) True
b) False 
Answer. A

Question. Flexible exchange is determined by ........................
a) Private party
b) Government
c) Foreign exchange market
d) None of these
Answer. C

Assertion and Reason Type Questions:

Read the following statements Assertion (A) and the Reason (R).
Choose one of the correct alternatives given below:
e) Both Assertion (A) and Reason (R) are True and Reason (R) is the correct explanation of Assertion (A)
f) Both Assertion (A) and Reason (R) are True and the Reason(R) is Not the correct explanation of Assertion (A)
g) Assertion (A) is True but Reason (R) is False
h) Assertion (A) is False but Reason (R) is True

Question. Assertion (A): In case of the floating exchange rate system the currency price of a nation is set by the forex market based on supply and demand relative to other currencies
Reason (R): Government intervenes in the foreign exchange market under Floating Exchange Rate System to restrict the fluctuations in the exchange rate with certain limits
Answer. C

Question. Assertion (A): Import of goods and services reflects demand of foreign currency
Reason (R): import of goods and services shows inflow of foreign exchange
Answer. C

Question. Assertion (A): Demand for foreign exchange and exchange rate moves in the same direction
Reason (R): when the exchange rate rises, domestic goods become cheaper in the international market
Answer. A

Question. Assertion (A): fixed exchange rate system is also known as floating exchange rate system
Reason (R): In fixed exchange rate system, currency of home country is tired with some external standard like gold etc.
Answer. D

Question. Assertion (A): Managed the floating rate system is a hybrid of a fixed exchange rate and a flexible exchange rate system
Reason (R): Central bank maintains reserves of foreign exchange under managed floating rate system to ensure that the exchange rate stays within the targeted value
Answer. B

1. Read the following paragraph and Answer the questions given below on the basis of the same:

Venezuelan President Nicolas Maduro carried out one of the greatest currency devaluations in history over the weekend – a 95% plunge that will rest the capacity of an already beleaguered Population to stomach even more pain.
The official rate for the currency we'll go from about 285, 000 per dollar to 6 million, a shock that officials tried to partly offset by raising the minimum wage 3, 500 per cent to the equivalent just $30 a month. While my Maduro boasted in Friday night's announcement that the International Monetary Fund wasn’t involved in the policies, aspects of the moves bore a resemblance to a Classic orthodox economic adjustment albeit with Some confusing twists.
-------- The Economic Times, August 20, 2018

Question. As a result of devaluation:
(a) exports from Venezuela will be increase
(b) imports in Venezuela will be increase
(c) exports from Venezuela will decrease
(d) both (b) and (c)
Answer. A

Question. Devaluation leads to:
(a) increasing supply of foreign currency in the international money market
(b) increase in supply of domestic currency in the international market
(c) increase in demand of foreign currency in the international market
(d) both (b) & (c)
Answer. D

Question. Devaluation of currency is possible in:
(a) managed to floating
(b) fixed exchange rate regime
(c) flexible exchange rate regime
(d) both (a) and (b)
Answer. B

Question. A substantial decrease in foreign reserves often leads to:
(a) appreciation of foreign currency
(b) depreciation of foreign currency
(c) devaluation of domestic currency
(d) devaluation of foreign currency
Answer. A

Important Questions for NCERT Class 12 Economics Bop And Foreign Exchange Rate

Short Answer: Question & Answer

Question. How does decrease in FDI in India act as a supply stock for foreign exchange?
Answer.  Decrease in FDI leads to a decrease in a supply of foreign exchange, for reasons other than change in exchange rate. It is a supply shock that cause a backward shift of supply curve of foreign exchange for the Indian economy. Consequently, equilibrium exchange will rise. More rupee are to be paid for buying a unit of foreign currency.

Question. What are the Sources of Supply of foreign exchange?
Answer.  These are the export of goods & services; investments by ROW in the resident country; receiving gifts, donations & grants from the ROW; remittances by the non-residents from the ROW; direct purchase made by the non-residents in the domestic country; other receipts involved in international transactions etc. The supply of foreign exchange is directly related to the exchange rate.

Question. How do the deficit BoP and surplus BoP impact the exchange rate?
Answer.  (i) Deficit Balance of Payment: If the balance of payment of a country show deficit, demand for foreign currency will increase. Accordingly, exchange rate is expected to rise. Domestic currency will depreciate in relation to foreign currency. (ii) Surplus Balance of Payment: If the balance of payment of a country shows surplus, availability of foreign currency will increase. Accordingly, exchange rate is expected to fall. Domestic currency will appreciate in relation to foreign currency.

Question. Define the term Foreign Exchange Rate.
Answer.  It refers to the rate at which one unit of currency of a country is exchanged for the currency of other country. In other words, it is the price of one currency in terms of another currency.

Question. What is depreciation of rupee? What is its likely impact on Indian imports and how?
Answer.  Depreciation of rupee is the fall in the value of Indian currency in relation with foreign currency. More rupees are now required to buy a unit of foreign currency. This will make foreign goods expensive to the buyers in India. As a result, import are likely to fall.

Question. State the sources of demand for foreign exchange.
Answer.  These are import of goods & services; investment in other countries; gifts & grants to abroad; direct purchase made in abroad; other payments involved in international transactions etc. The demand for foreign exchange is made for the purpose of payments of foreign loans, import of products, making investments & giving loans to other countries, tour & travel in abroad etc. The demand for foreign exchange is inversely related to the exchange rate.

Question. Explain the determination of foreign Exchange Rate.
Answer.  The exchange rate is the price of a currency in terms of another currency. It depends upon the different foreign exchange regimes which are Fixed Exchange Rate System & Flexible Exchange Rate System. Fixed Exchange Rate System refers to the system in which the rate of exchange is
determined by govt. or monetary authorities. It can be classified into Gold Standard System or Mint Parity of Exchange & Adjustable Peg System. The fixed exchange rate system had certain merits viz. it ensured stability & fluctuations had been avoided; encouraged international trade due to low risk & lesser uncertainty & coordinated the macroeconomic policies across the different countries. But it had certain shortcomings viz. need of huge international reserves of gold; restriction in movement of capital due to the need of huge reserves of gold; discouraged venture capital; & rigid in resource allocation.
Flexible Exchange Rate System refers to such a rate of exchange which is determined by the demand for & supply of the foreign exchange in the foreign exchange market. Under this system, the govt. or central bank does not intervene in the determination of exchange rates. The exchange rate is determined by the free play of two forces viz. demand & supply of concerned foreign currencies. The rate of exchange is determined when both demand & supply of foreign exchange are equal to each other.

Question. How do we finance the deficit on current account BOP in case officially reserves with the RBI are not moved?
Answer.  We are left with on two alternatives only:
1. We borrow from rest of the world;
2. We sell our assets (financial assets like stock and bonds, and physical assets (like plant and machinery) to rest of the world.

Question. Explain the role of Central Bank during depreciation.
Answer.  Due to depreciation, the price of imports rises due to which the price of essential products viz crude oil rises which leads to increase in petroleum prices & further which leads to inflation in the economy. The central Bank can resolve this under the managed floating system. The Central Bank will release more of dollars in the market & reduce the supply of INR. Consequently, the supply of dollars rises which leads to reduce its price, & on the other hand, the value of INR rises due to decline in availability. This process leads the exchange rate back to its original one later. Due to this act, the managed floating is also known as dirty floating.

Question. How is depreciation of Indian rupee likely to affect Indian export? Explain.
Answer.  Depreciation of the domestic currency implies that the domestic currency (rupee) loses its value in relation to foreign currency (say US Dollar). Now, more rupee are required to buy a dollar, or a dollar can now buy more goods in domestic in the domestic economy.
Accordingly, exports are expected to rise.

Question. Differentiate between Depreciation and Devaluation.
Answer.  Depreciation means decline in external value of a domestic currency in relation to a foreign currency, while the term devaluation also mean the same. But the difference is that depreciation takes place due to the outcome of changes in the market forces i.e increase in demand or decrease in supply of foreign exchange, while devaluation means a deliberate action taken by the Govt. in order to correct its deficit BOP by discouraging imports & encouraging exports which will increase the inflow & reduce the outflow of foreign exchange. Thus, depreciation is the part of flexible exchange rate system while devaluation is the part of fixed exchange rate system.

Question. Will you always appreciate a rise in exchange rate as a means to boost our exports?
Answer.  No. Because a rise in exchange rate may not always lead to a rise in our export earnings. A rise in exchange rate is beneficial only elasticity of demand for our exports is greater than unity. Because, it is only then that the total expenditure on our exports will rise in response to a fall in prices of domestic goods (in terms of the foreign currency) yields greater revenue only when the elasticity of demand for our exports is greater than unity.

Question. Define the term Foreign Exchange Market.
Answer.  It refers to the place where foreign currencies are bought & sold. It acts to transfer the purchasing power between the countries (transfer function); provides credit for international trade (credit function); make provision for hedging facilities i.e. protection against the risk related to variations in forex rate (hedging function).

Question. Give the three sources of demand and supply of foreign exchange Sources of Demand for Foreign Exchange
Answer.  • To purchase goods and services from the rest of world.
• To purchase financial assets (i.e.., to invest in bonds and equity shares) in a foreign country. 
• To invest directly in shops, factories, buildings in foreign countries.
Sources of Supply of Foreign Exchange
• Direct purchase by foreigners in domestic market.
• Direct investment by foreigners in domestic market.
• Remittances by non-residents living abroad.

Question. Distinguish between currency appreciation and currency depreciation
Answer. Currency appreciation is an increase in the value of country’s currency with respect to one or more foreign reference currencies, in a floating exchange rate system. Currency depreciation is the loss of value of a country’s currency with respect to one or more foreign reference currencies, in a floating exchange rate system.

Question. Explain the effect of appreciation and depreciation up on exports and imports
Answer. 
Appreciation Depreciation       Exports Decrease
Exports Increase                     Imports Increase
Imports Decrease                   National Income
Increase                                  National Income Decrease

Question. Explain the determination of exchange rate in a flexible exchange rate market system with the help of diagram.
Answer.  Determination of Equilibrium Foreign Exchange Rate:
o Equilibrium FER is the rate at which demand for and supply of foreign exchange is equal.
o Under free market situation, it is determined by market forces i.e., demand for and supply of foreign exchange.
o There is inverse relation between demand for foreign exchange and exchange rate.
o There is direct relationship b/w supply of foreign exchange and exchange rate. Due to above reasons demand curve downward sloping and supply curve is upward sloping curve Graphically intersection of demand Curve and supply curve determines the equilibrium foreign exchange rate. (Diagram with explanation)

Question. Define foreign exchange rate.
Answer. Foreign exchange rate is the rate at which currency of one country can be exchanged for currency of another country.

Question. What do you mean by Foreign Exchange Market?
Answer. The foreign exchange market is the market where international currencies are traded for one another.

Question. What is meant by Fixed Exchange Rate?
Answer. Fixed Rate of exchange is a rate that is fixed and determined by the government of a country and only the government can change it.

Question. What is equilibrium rate of exchange?
Answer. Equilibrium exchange rate occurs when supply of and demand for foreign exchange are equal to each other.

Question. Define flexible exchange rate.
Answer. Flexible rate of exchange is that rate which is determined by the demand and supply of different currencies in the foreign exchange market.

Question. What is meant by appreciation of currencies?
Answer. Appreciation of a currency occurs when its exchange value in relation to currencies of other country increases.

Question. Define Spot exchange rate.
Answer. The spot exchange rate refers to the rate at which foreign currencies are available on the sport.

Question. Define forward market.
Answer. Market for foreign exchange for future delivery is known as the forward market.

Question. What is meant by balance of payments?
Answer. Balance of payments refers to the statement of accounts recording all economic transactions of a given country with the rest of the world.

Question. What do you mean by balance of trade?
Answer. Balance of trade is the difference between the value of imports and exports of only physical goods.

Question. The balance of trade shows a deficit of Rs. 600 crores, the value of exports is Rs.1000 crores. What is value of Imports?
Answer. Balance of Trade = Exports of goods – import of goods
Import of good = Export of goods – (B.O.T)
= 1000- (-600)
= Rs. 1600.

Question. What is the balance of visible items in the balance of payments account called?
Answer. Balance of trade

Question. What do you mean by disequilibrium in BOP?
Answer. Disequilibrium in BOP is means either there is a surplus or deficit in balance of payment account.

Question. List two items of the capital account of BOP account.
Answer. i) external assistance ii) commercial borrowing iii) foreign investment

Question. Which transactions bring balance in the BOP account?
Answer. Accommodating transactions bring balance in the BOP account.

Question. Define autonomous items in BOP.
Answer. Autonomous items in BOP refers to international economic transaction that take place due to some economic motive such as profit maximization. These items are independent of the state of the country balance of payments.

Question. What is the other name of autonomous items in the BOP?
Answer. The other name of autonomous items in BOP is above the line item.

Question. When does a situation of deficit in BOP arises?
Answer. A situation of deficit in BOP arise when autonomous receipts are less than autonomous payments.

Question. What is meant by managed floating?
Answer. It is a system that allows adjustments in exchange rate according to a set of rules and regulations which are officially declared in the foreign exchange market.

Question. What is meant by dirty floating?
Answer. Manipulate the exchange rate without following the guidelines issued by IMF is called dirty floating.

Question. What is the impact of appreciation of currency on the demand for foreign exchange?
Answer. It is the difference between monetary value of exports and imports of material goods or visible items.

Question. What is the impact of appreciation of currency on the supply of foreign exchange?
Answer. A balance of payment is a statement of double entry system of all economic transactions between residents of a country and the residents of foreign countries during a given period of time.

Question. What is the impact of depreciation of currency on the demand for foreign exchange?
Answer. When the value of imports is more than value of exports.

Question. What is the impact of depreciation of currency on the supply of foreign exchange?
Answer. 800 Crores.

Question. Distinguish between devaluation and depreciation of domestic currency.
Answer. Visible items Watch, Petrol, Electronic item.

Question. Giving reasons state whether the following statements are true or false :
(i) Excess of foreign exchange receipts over foreign exchange payments on account of accommodating transactions equals deficit in the balance of payments.
(ii) Export and import of machines are recorded in capital account of the balance of payments account.
Answer. (i) Direct Foreign Investment
(ii) Loans

❑ Balance of trade is the net difference of Import and export of all visible items between the normal residents of a country and rest of the world.
❑ Autonomous items are those items of balance of payment which are related to such transaction as are determined by the motive of profit maximisation and not to maintain equilibrium in balance of payments. These items are generally called ‘Above the Line items’ in balance of payment.
❑ Accommodating item refers to transactions that take place because of other activity in Balance of Payment. These transactions are meant to restore the Balance of Payment identity. These items are generally called ‘Below the Line items’.
❑ Foreign exchange rate refers to the rate at which one unit of currency of a country can be exchanged for the number of units of currency of another country. 

❑ The epitome of the fixed exchange rate system was the gold standard in which each participant country committed itself to convert freely its currency into gold at a Fixed Price.
❑ Merit of Fixed Exchange Rate
(i) Stability in exchange rate
(ii) Promotes capital movement and international trade.
(iii) No scope for speculation.
❑ Demerits of Fixed Exchange Rate
(i) Need to hold foreign exchange reserves.
(ii) No automatic adjustment in the ‘Balance of payments.’
(iii) Enhance dependence on external sources.
❑ In a system of flexible exchange rate (also known as floating exchange rates), the exchange rate is determined by the forces of market demand and supply of foreign exchange.
❑ The demand of foreign exchange have inverse relation with flexible exchange
rate. If flexible exchange rate rise the demand of foreign exchange falls.
Vice versa.

❑ Sources of Demand for Foreign Exchange
(a) To purchase goods and services from the rest of world.
(b) To purchase financial assets (i.e., to invest in bonds and equity shares)
in a foreign country.
(c) To invest directly in shops, factories, buildings in foreign countries.
(d) To send gifts and grants to abroad.
(e) To speculate on the value of foreign currency.
(f) To undertake foreign tours.

❑ The supply of foreign exchange have positive relation with foreign exchange rate. If foreign exchange rate rise the supply of foreign exchange rate also rise and vice versa.

❑ Sources of Supply of Foreign Exchange
(i) Direct purchase by foreigners in domestic market.
(ii) Direct investment by foreigners in domestic market.
(iii) Remittances by non-residents living abroad.
(iv) Flow of foreign exchange due to speculative purchases by N.R.I.
(v) Exports of goods and services.

❑ Merits of Flexible Exchange Rate
(i) No need to hold foreign exchange reserves
(ii) Leads to automatic adjustment in the ‘balance of payments’.
(iii) To increase the efficiency in the economy by achieving optimum resources allocation.
(iv) To remove obstacles in the transfer of capital and trade.

❑ Demerits of Flexible Exchange Rate
(i) Fluctuations in foreign exchange rate.
(ii) Encourages speculation.
(iii) Discourages international trade and investment.
❑ In currency depreciation, there is a fall in the value of domestic currency
in term of foreign currency. In currency appreciation, there is a rise in the value of domestic currency in term of foreign currency.
❑ In currency appreciation, there is a rise in the value of domestic currency in terms of foreign currency.
❑ Equilibrium flexible exchange rate is determined at a level where demand for and supply of foreign exchange are equal to each other.
❑ Managed floating system is a system in which the central bank allows the exchange rate to be determined by market forces but intervenes at times to influence the rate.

VERY SHORT ANSWER TYPE QUESTIONS 

Question. What is meant by balance of trade?
Answer: It is the difference between monetary value of exports and imports of material goods or visible items.

Question. Define balance of payment.
Answer: A balance of payment is a statement of double entry system of all economic transactions between residents of a country and the residents of foreign countries during a given period of time.

Question. When is there a deficit in the balance of trade.
Answer: When the value of imports is more than value of exports.

Question. The balance of trade shows a deficit of Rs. 300 crs. and the value of exports is Rs. 500 crs. What is the value of imports?
Answer: 800 Crores.

Question. List two items included in the balance of trade account.
Answer: Visible items Watch, Petrol, Electronic item.

Question. List two items of the capital accounts of balance of payment.
Answer: (i) Direct Foreign Investment
(ii) Loans

Question. Give meaning of managed floating exchange rate.
Answer: Exchange rate influenced by the intervention of the central bank in the foreign exchange market.

Question. What is meant by invisible items?
Answer: Invisible items are all those type of services which are exported and imported.

Question. What is meant by unilateral transfer?
Answer: These refers to one sided transfers from one country to other. These are not trading transactions.

Question. What is meant by Autonomous transactions?
Answer: Autonomous transactions refer to international economic transactions in the current and capital account that are undertaken for profit.

Question. Write the name of those economic transactions which are made by the government to make equilibrium in balance of payment.
Answer: Accommodating items.

Question. What do you mean by Fixed Exchange Rate?
Answer: Fixed exchange rate is the rate which is officially fixed in terms of Gold or any other currency by the govt. or adjusted only frequently.

Question. Define Flexible Exchange rate?
Answer: Flexible exchange rate is determined by demand for and supply of a given currency in foreign exchange market.

Question. State two merits of Flexible Exchange Rate.
Answer: (i) No need to hold foreign exchange reserve.
(ii) Optimum resource allocation.

Question. State two demerits of Flexible Exchange Rate.
Answer: (i) Fluctuations in foreign exchange rate.
(ii) Encourages speculation.

Question. State two merits of fixed exchange rate.
Answer: (i) Stability in Exchange rate.
(ii) No scope for speculation.

Question. State two demerits of fixed exchange rate.
Answer: (i) Need to hold foreign exchange reserves.
(ii) No automatic adjustment in the ‘Balance of Payments.’

Question. What is the slope of demand curve of foreign exchange?
Answer: Negative slope.

Question. What is the slope of supply curve of Foreign Exchange?
Answer: Positive slope.

Question. What will be the effect on exports, if foreign exchange rate increases?
Answer: Exports will increase because Indian goods have become cheaper for foreigners. 

Question. Define Devaluation of Domestic Currency.
Answer: Import will decrease because foreign goods have become costlier for Indians.

Question. What is meant by Depreciation of Domestic Currency?
Answer: Devaluations means to reduce parity rate of its currency with respect of gold or any other currency by the Government.

Question. What is meant by Appreciation of Domestic Currency?
Answer: When the value of domestic currency reduce with respect to other currency by the demand and supply forces of foreign exchange in a free exchange market.

HOTS 

Question. In which circumstances, the devaluation of currency will be in favour of economy?
Answer: When economy adopt the policy of Export Promotions.

Question. In which circumstances the appreciation of currency will be non favourable for the economy?
Answer: When we adopt the policy of Import Substitution.

Question. Under which circumstances, the purchasing power of foreign currency increases in comparison to domestic currency?
Answer: Capital account records capital transfer such as loans and investment between one country and the rest of the world which causes a change in the asset or liability status of the residents of a country or its government.

Question. With the help of which item BOP gets balanced?
Answer: With the help of international loans.

Question. Does BOP always remain balanced?
Answer: Always in equilibruim in the sense of accounting.

Key Points for Class 12 Economics Chapter 6 Open Economy Macroeconomics

Foreign Exchange:- It means the stock of foreign currency. For example- US Dollar, British Pound etc. are foreign exchange from the view point of India.

Foreign Exchange Rate
It is the price paid in domestic currency in order to get one unit of foreign currency For example $1 = Rs. 45
Types of Foreign Exchange Rate

1. Fixed Exchange Rate
When exchange rate is officially declared and it is fixed.

2. Flexible Exchange Rate/ Floating Exchange Rate
The rate which is determined by demand and supply of foreign exchange.
Determination of Exchange Rate/ Equilibrium Exchange Rate
The exchange rate of a country‟s currency is determined by the demand and supply of foreign exchange.

Sources of demand for foreign exchange:-
People demand for foreign exchange for the following purpose:-
a) To purchase goods and service from other countries (Imports)
b) To send gifts and grants to abroad
c) To purchase financial assets
d) To speculate the value of foreign currencies.
There is inverse relationship between demand of foreign currencies for foreign exchange and foreign exchange rate.

Sources of supply for foreign exchange:-
a) Exports of the country to the rest of the world
b) Direct foreign investment in home country
c) Speculative purchase by the non- residents in the domestic market.
d) Direct purchase of the goods and services by the non- residents in the domestic market
e) Gifts and grants of the non- residents.
These is direct relationship between Supply of foreign exchange and foreign exchange rate.

Equilibrium of Exchange rate
It is determined at a point where demand and supply of foreign exchange are equal. 

In the diagram Demand Curve (DD) and Supply Curve (SS) intersect each other at the point E. Equilibrium exchange rate is OR determined.