CBSE Class 12 Economics Balance of Payments and Foriegn Exchange Rate

Foreign Exchange refers to all currencies other than the domestic currency of a given country.
Foreign exchange rate is the rate at which currency of one country can be exchanged for currency of another country.
Foreign Exchange Market: The Foreign Exchange market is the market where the national currencies are traded for one another.

Functions of Foreign Exchange Market:
1. Transfer function: It transfers the purchasing power between countries.
2. Credit function: It provides credit channels for foreign trade
3. Hedging function: It protects against foreign exchange risks.

FIXED EXCHANGE RATE SYSTEM: Fixed exchange rate is the rate which is officially fixed by the government, monetary authority and not determined by market forces.

FLEXIBLE EXCHANGE RATE: Flexible exchange rate is the rate which is determined by forces of supply and demand in the foreign exchange market.

DEMAND FOR AND SUPPLY OF FOR FOREIGN EXCHANGE
Demand for foreign exchange:
1. To purchase goods and services from other countries
2. To send gifts abroad
3. To purchase financial assets (shares and bonds)
4. To speculate on the value of foreign currencies
5. To undertake foreign tours
6. To invest directly in shops, factories, buildings
7. To make payments of international trade.

Supply of foreign exchange:
Foreign currencies flow into the domestic economy due to the following reason.
1. When foreigners purchase home countries goods and services through exports
2. When foreigners invest in bonds and equity shares of the home country.
3. Foreign currencies flow into the economy due to currency dealers and speculators.
4. When foreign tourists come to India
5. When Indian workers working abroad send their saving to families in India.

EQUILIBRIUM IN THE FOREIGN EXCHANGE MARKET
The equilibrium exchange rate is determined at a point where demand for and supply of foreign exchange are equal. Graphically interaction of demand and supply curve determines the equilibrium exchange rate of foreign currency.

Managed Floating: This is the combination of fixed and flexible exchange rate. Under this, country manipulates the exchange rate to adjust the deficit in the B.O.P by following certain guidelines issued by I.M.F.
Dirty floating: If the countries manipulate the exchange rate without following the guidelines issued by the I.M.F is called as dirty floating.

BALANCE OF PAYMENTS: MEANING AND COMPONENTS
Meaning: The balance of payments of a country is a systematic record of all economic transactions between residents of a country and residents of foreign countries during a given period of time.

BALANCE OF TRADE AND BALANCE OF PAYMENTS
Balance of trade: Balance of trade is the difference between the money value of exports and imports of material goods (visible item)
Balance of payments: Balance of payments is a systematic record of all economic transactions between residents of a country and the residents of foreign countries during a given period of time. It includes both visible and invisible items. Hence the balance of payments represents a better picture of a country’s economic transactions with the rest of the world than the balance of trade.

STRUCTURE OF BALANCE OF PAYMENT ACCOUNTING
A balance of payments statement is a summary of a Nation’s total economic transaction undertaken on international account. There are two types of account.

1. Current Account: It records the following 03 items.
a) Visible items of trade: The balance of exports and imports of goods is called the balance of visible trade.
b) Invisible trade: The balance of exports and imports of services is called the balance of invisible trade E.g. Shipping insurance etc.
c) Unilateral transfers: Unilateral transfers are receipts which resident of a country receive (or) payments that the residents of a country make without getting anything in return e.g. gifts.
The net value of balances of visible trade and of invisible trade and of unilateral transfers is the balance on current account.

2. CAPITAL ACCOUNT: It records all international transactions that involve a resident of the domestic country changing his assets with a foreign resident or his liabilities to a foreign resident.

VARIOUS FORMS OF CAPITAL ACCOUNT TRANSACTIONS
1. Private transactions: These are transactions that are affecting assets (or) liabilities by individuals.
2. Official transactions: Transactions affecting assets and liabilities by the government and its agencies.
3. Direct Investment: It is the act of purchasing an asset and at the same time acquiring and control of it.
4. Portfolio investment: It is the acquisition of assets that does not give the particular control over the asset.
The net value of balances of direct and portfolio investment is called the balance on capital account.

OTHER ITEMS IN THE BALANCE OF PAYMENT
They are included since the full balance of payments account must balance. These items are as follows.
1) Errors and Omissions: They may arise due to the presence of sampling and due to his honesty.
2) Official reserve transactions: All transactions except those in this category may be termed as autonomous transactions. They are so called because they were entered into with some independent motive. Balance of payments always balance.

AUTONOMOUS AND ACCOMMODATING ITEMS
Autonomous items: Autonomous items in the B.O.P refer to international economic transactions that take place due to some economic motive such as profit maximization. These items are often called above the line items in the B.O.P.
The balance of payments is in a deficit if the autonomous receipts are less than autonomous payments. The monetary authorities may finance a deficit by depleting their reserves of foreign currencies, or by borrowing from I.M.F.

Accommodating items: Accommodating items in the B.O.P. refer to transactions that occur because of other activity with the B.O.P such as government financing. Accommodating items are also referred to as below the line of items.

DISEQUILIBRIUM THE BALANCE OF PAYMENTS
There are a number of factors that cause disequilibrium in the balance of payments showing either a surplus or deficit. These causes are categorized into 3 factors.

I Economic factors: Large scale development expenditure that may cause large imports.
Cyclical fluctuations in general business activities such as recession or depression.
High domestic prices may result in imports.

II Political factors: Political instability may cause large capital outflows and hamper the inflows of foreign capital.

III Social factors: Changes in tastes, preferences and fashions may affect imports and exports.

ASSERTION AND REASON BASED QUESTIONS

Question. Assertion (A): Purchase of second-hand machinery from abroad is not recorded in balance of payment.
Reason (R): Sale and purchase of second-hand goods from abroad are not included in the estimation of national income.
a) Both Assertion (A) and Reason (R) are true and Reason (R) is the correct explanation of Assertion (A).
b) Both Assertion (A) and Reason (R) are true and Reason (R) is not the correct explanation of Assertion (A).
c) Assertion (A) is true, but Reason (R) is false.
d) Assertion (A) is false, but Reason (R) is true
Answer : d Sale and purchase of second-hand goods from abroad are not included in the estimation of national income and purchase of second-hand machinery from abroad is also recorded in balance of payment so (d) is the correct answer.

Question. Assertion (A): Accommodating items of trade are undertaken to maintain the balance in the BOP account.
Reason (R): Accommodating items are net consequences of autonomous transactions that are undertaken to correct disequilibrium in autonomous items of BOP.
a) Both Assertion (A) and Reason (R) are true and Reason (R) is the correct explanation of Assertion (A).
b) Both Assertion (A) and Reason (R) are true and Reason (R) is not the correct explanation of Assertion (A).
c) Assertion (A) is true but Reason (R) is false.
d) Assertion (A) is false but Reason (R) is true
Answer : a Accommodating items of trade are undertaken in order to maintain the balance in the BOP account, because: Accommodating items are net consequences of autonomous transactions that are undertaken to correct disequilibrium in autonomous items of BOP.

Question. Assertion (A): Fixed Exchange rate system involves active involvement of central bank/ government of the respective countries. Reason (R): In fixed exchange rate system, once the exchange rate is decided it is usually kept as fixed in order to maintain the stability in economic transactions.
a) Both Assertion (A) and Reason (R) are true and Reason (R) is the correct explanation of Assertion (A).
b) Both Assertion (A) and Reason (R) are true and Reason (R) is not the correct explanation of Assertion (A).
c) Assertion (A) is true but Reason (R) is false.
d) Assertion (A) is false but Reason (R) is true
Answer : b Fixed Exchange rate system involves active involvement of central bank/ government of the respective countries. In fixed exchange rate system, once the exchange rate is decided it is usually kept as fixed in order to maintain the stability in economic transactions. Both the statements are correct but reason is not correct.

Question. Assertion (A): India’s current account balance (CAB) recorded a surplus of US$ 19.8 billion (3.9% of GDP) in Q1 of 2020-2021.
Reason (R): There has been a steeper decline in merchandise imports relative to exports in past few years.
a) Both Assertion (A) and Reason (R) are true and Reason (R) is the correct explanation of Assertion (A).
b) Both Assertion (A) and Reason (R) are true and Reason (R) is not the correct explanation of Assertion (A).
c) Assertion (A) is true but Reason (R) is false.
d) Assertion (A) is false but Reason (R) is true
Answer : a India’s current account balance (CAB) recorded a surplus of US$ 19.8 billion (3.9% of GDP) in Q1 of 2020-2021, as there has been a steeper decline in merchandise imports relative to exports in past few years.

Question. Assertion (A): Increased lending abroad are recorded on the debit side of the capital account.
Reason (R): Lending affect the assets and liabilities of the economy and involves outflow of income.
a) Both Assertion (A) and Reason (R) are true and Reason (R) is the correct explanation of Assertion (A).
b) Both Assertion (A) and Reason (R) are true and Reason (R) is not the correct explanation of Assertion (A).
c) Assertion (A) is true but Reason (R) is false.
d) Assertion (A) is false but Reason (R) is true
Answer : a Increased lending abroad are recorded on the debit side of the capital account, because lending affects the assets and liabilities of the economy and involves outflow of income.

Question. Assertion (A): Depreciation of domestic currency leads to rise in exports.
Reason (R): Depreciation of domestic currency makes domestic currency relatively cheaper, which leads to increase in exports.
a) Both Assertion (A) and Reason (R) are true and Reason (R) is the correct explanation of Assertion (A).
b) Both Assertion (A) and Reason (R) are true and Reason (R) is not the correct explanation of Assertion (A).
c) Assertion (A) is true but Reason (R) is false.
d) Assertion (A) is false but Reason (R) is true
Answer : a Depreciation of domestic currency leads to rise in export, because depreciation of domestic currency makes domestic currency relatively cheaper, which leads to increase in exports.

Question. Assertion (A): Managed Floating Exchange rate system is a combination of fixed and flexible exchange rate systems.
a) Reason (R): In managed floating exchange rate system, central bank decides the limit of Both Assertion (A) and Reason (R) are true and Reason (R) is the correct explanation of Assertion (A).
b) Both Assertion (A) and Reason (R) are true and Reason (R) is not the correct explanation of Assertion (A).
c) Assertion (A) is true but Reason (R) is false.
d) Assertion (A) is false but Reason (R) is true
Answer : a Managed Floating Exchange rate system is a combination of fixed and flexible exchange rate systems.
In managed floating exchange rate system, central bank decides the limit of the exchange rate and within the limit; exchange rate is decided by market forces of demand and supply of foreign exchange. Both the statements are correct and reason is also correct.

Question. Assertion (A): Appreciation of domestic currency means a rise in the price of domestic currency
Reason (R): Appreciation leads to increase in exports.
a) Both Assertion (A) and Reason (R) are true, and Reason (R) is the correct explanation of Assertion (A).
b) Both Assertion (A) and Reason(R) are true, and Reason (R) is not the correct explanation of Assertion (A).
c) Assertion (A) is true, but Reason (R) is false.
d) Assertion (A) is false, but Reason (R) is true.
Answer : c Appreciation of domestic currency means a rise in the price of domestic currency, But Appreciation do not lead to increase in exports, so (c) is the correct answer.

Question. Assertion (A): Current account transactions bring about change in the capital stock of a country.
Reason (R): 'Make in India' will increase supply (inflow) of foreign exchange in India causing improvement in the balance of payments position.
a) Both Assertion (A) and Reason (R) are true and Reason (R) is the correct explanation of Assertion (A).
b) Both Assertion (A) and Reason (R) are true and Reason (R) is not the correct explanation of Assertion (A).
c) Assertion (A) is true but Reason (R) is false.
d) Assertion (A) is false but Reason (R) is true
Answer : d 'Make in India' will increase supply (inflow) of foreign exchange in India causing improvement in the balance of payments position but Current account transactions do not bring change in the capital stock of a country so (d) is the correct answer.

Question. Assertion (A): All transactions recorded in Balance of Payment are autonomous transactions.
Reason (R): Autonomous transactions are recorded in both current and capital account of BoP.
a) Both Assertion (A) and Reason (R) are true and Reason (R) is the correct explanation of Assertion (A).
b) Both Assertion (A) and Reason (R) are true and Reason (R) is not the correct explanation of Assertion (A).
c) Assertion (A) is true but Reason (R) is false.
d) Assertion (A) is false but Reason (R) is true.
Answer : d Autonomous transactions are recorded in both current and capital account of BOP, However all transactions recorded in Balance of Payment are not autonomous transactions so (d) is the correct answer.

Question. Assertion (A): A country always tries to balance the BOP i.e., balance in current account equals to balance in capital account.
Reason (R): Balanced BOP indicates stable economic relation with rest of the world.
a) Both Assertion (A) and Reason (R) are true, and Reason (R) is the correct explanation of Assertion (A).
b) Both Assertion (A) and Reason (R) are true and Reason (R) is not the correct explanation of Assertion (A).
c) Assertion (A) is true but Reason (R) is false.
d) Assertion (A) is false but Reason (R) is true.
Answer : a A country always tries to balance the BOP i.e. balance in current account equals to balance in capital account, because a balance BOP indicates stable economic relation with rest of the world.

Question. Assertion (A): If an Indian buys a UK Car Company, it renters’ capital account transactions as a debit item.
Reason (R): Sale of assets like sale of share of an Indian company to a Chinese customer is a credit item
a) Both Assertion (A) and Reason (R) are true and Reason (R) is the correct explanation of Assertion (A).
b) Both Assertion (A) and Reason (R) are true and Reason (R) is not the correct explanation of Assertion (A)
c) Assertion (A) is true but Reason (R) is false.
d) Assertion (A) is false but Reason (R) is true
Answer : a If an Indian buys a UK Car Company, it enters capital account transactions as a debit item and Sale of assets like sale of share of an Indian company to a Chinese customer is a credit item, Both the statements are correct and reason is also correct.

CASE STUDY- 1

Read the following hypothetical text and answer the given questions: -

Exchange rate between Indian Rupee and US Dollar has changed from 71. 49 (November, 2020) to 72.82 (January 2021) through changes to market forces of demand and supply. Therefore, it is believed that India's balance of payments this year going to be ‘’very very strong’’ Commerce and Industry Minister Piyush Goyal said on Monday.

Question. Change from 1$ = 71.49 INR to 72.82 is called as……………….
a) Appreciation
b) Depreciation
c) Revaluation
d) Devaluation
Answer: B

Question. This kind of determination is applicable in ………. system of exchange rate
a) Flexible exchange rate system
b) Fixed exchange rate system
c) Managed floating
d) None of above
Answer: A

CASE STUDY- 2

Read the following hypothetical text and answer the given questions: -

Each nation has its own currency when monetary transactions are conducted within the national borders, payments are made in the currency of that country for example Indian currency is called rupee. To be more exact it is called Indian rupee payments within the national borders Of India are made in Indian rupees. Similarly, each other nation has its own currency for example Pakistan currency is called Pakistani rupee USA currency US dollar Kuwait currency Kuwaiti Dinar UAE currency dirham and so on payments within the nation borders of Pakistan are made in Pakistani rupees payment within the national border of USA is USA dollars, etc. When transactions are conducted across National borders one currency must be converted into another. Conversion rate between two currencies is decided by two ways first fixed exchange rate second floating or flexible exchange rate.

Question. Exchange rate refer to the rate at which the following is exchanged:
(a) Goods
(c) Services
(b) Currencies
(d) All the above
Answer: B

Question. Who fixed the flexible exchange rate:
(a) Market force
(b) Government
(c) Both a and b
(d) None of these
Answer: A

Question. ___________refers to a system in which exchange rate for a currency is fixed by the government.
a) Fixed exchange rate
b) flexible exchanged rate
c) floating exchange rate
d) none of above
Answer: A

CASE STUDY- 3

Read the following hypothetical text and answer the given questions: -
India's foreign exchange reserves have jumped by $100 billion in 10 months to a record high of $534.5 billion. The rise has been led by strong foreign fund inflows recently and decline in import bill due to dip in crude oil prices and trade impact following COVID-19 pandemic. Reduced imports of gold also cut down India's import bill.

Question. Import of Petroleum from Iran will be mentioned:
a) Credit side of Capital Account
b) Debit side of Capital Account
c) Credit side of Current Account
d) Debit side of Current Account
Answer: D

Question. Increase in import duty of gold will lead to:
a) Reduction in import of gold
b) Import of gold will increase
c) No effect on import of gold
d) Outflow of Foreign Exchange
Answer: A

Question. India's foreign exchange reserves has jumped high. The reason may be:
a) Inflow foreign exchange
b) Outflow of foreign exchange
c) Autonomous payments over Autonomous Receipts
d) All the above
Answer: A

Very Short Answer type Questions

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

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

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

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

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

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 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. 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 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 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. 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. 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.

Short Answer type Questions

Question. Why is foreign exchange demanded?
Answer: Foreign exchange is demanded for the following purposes.
a) Payment of International loans
b) Gifts and grants to rest of the world
c) Investment in rest of the world.
d) Direct purchases abroad for goods and services as well as imports from rest of the world.

Question. When price of a foreign currency falls, the supply of that foreign currency also fall why?
Answer: When price of a foreign currency falls it makes exports, investment by foreign residents costlier as a result supply of foreign currency falls.

Question. Why does the demand for foreign exchange rise, when it price falls?
Answer: With a fall in price of foreign exchange , the exchange value of domestic currency increases and that of foreign currency falls. This implies that foreign goods become cheaper and their domestic demand increases. The rising domestic demand for foreign goods implies higher demand for foreign exchange. So there is inverse relationship between price and demand for foreign exchange.

Question. What determines the flow of foreign exchange in to the country?
Answer: Following factors contribute to the flow of foreign exchange in to the country.
a) Purchases of domestic goods by the foreigners
b) Direct foreign investment and portfolio investment in the home country.
c) Speculative purchase of foreign exchange.
d) When foreign tourists come to India.

Question. Distinguish between autonomous and accommodating transaction of balance of payment account.
Answer: Autonomous transactions are done for some economic consideration such as profit, such transactions are independent of the state of B.O.P. Accommodating transactions are under taken to cover the deficit/surplus in balance of payments.

Give two examples explain why there is a rise in demand for a foreign currency when its price falls.
Answer:

When price of foreign currency falls, imports are cheaper. So, more demand for foreign exchange by importers.
Tourism abroad is promoted as it becomes cheaper. So demand for foreign currency rises.

Distinguish between fixed and flexible foreign exchange rate.
Answer: When foreign exchange rate is fixed by Central Bank/government, it is called fixed exchange rate. When foreign exchange rate is determined by market forces/mechanism, it is flexible exchange rate.

Question. Foreign exchange refers to:
(a) the price of one currency in terms of gold in the domestic market
(b) the price of one currency determined by government of other country
(c) the price of one currency in relation to other currencies in the international money market
(d) none of these
Answer: C

Question. Exchange rate is the price of a currency expressed in terms of:
(a) gold
(b) metal
(c) another currency
(d) none of these
Answer: C

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) Likely to rise and fall both
(d) Not affected
Answer: B

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) To rise or to fall
(d) To remain unaffected
Answer: A

Fill in the blanks:

Question. When exchange rate is fixed by the Government or the central bank, it is called _______.
Answer: fixed exchange rate 

Question. ______is the exchange rate determined by the market forces of supply and demand of foreign exchange.
Answer: Floating exchange rate 

Question. When in the foreign exchange market, the price of foreign currency rises in terms of domestic currency, it is termed ______as of domestic currency.
Answer: depreciation 

Question. ______is said to occur when the exchange rate is increased by the official action (government) under the fixed exchange rate system.
Answer: Devaluation

True or False:

Question. Exports are the source of demand for foreign exchange.
Answer: False.

Question. Floating exchange rate is determined by government.
Answer: False

Question. Decrease in demand for foreign currency leads to currency appreciation.
Answer: True.

Question. In case of currency appreciation, less rupees are to be paid to buy one US dollar.
Answer: True

Question. In order to restore the value of depreciating domestic currency, central bank sells the US dollars in the international money market.
Answer: True

Short Answer Type Questions

Question. Explain why there is a fall in demand for Foreign Exchange when its price rises.
OR
When price of foreign currency rises, its demand falls. Explain why ? 
Answer: When price of foreign currency rises it makes imports costlier. This leads to fall in demand for imports. As a result demand for foreign exchange falls.

Question. Give the meanings of ‘devaluation and depreciation’ of domestic currency.
Answer: When price of domestic currency falls under Fixed Exchange Rate System, it is called ‘devaluation’. When price of domestic currency falls under Flexible Exchange Rate System, it is called ‘depreciation’.

Question. What is Depreciation of Rupee ? What is its likely impact on Indian imports and how ?
OR
Explain the effect of depreciation of domestic currency on exports.
OR
Explain how ‘Depreciation of currency’ promotes exports of a country? 
Answer: When exchange rate rises, the value of domestic currency, rupee in case of India, falls. It is Depreciation of Rupee. 1 It makes imports costly because to import one unit of foreign currency worth of goods and services, the domestic purchasers have to pay with more rupees. Since imports become costly, imports fall.
When price of foreign currency in terms of domestic currency rises in the foreign exchange market, it is termed as depreciation of domestic currency. Any depreciation of home currency results in increase in exports of the country since it increases the global competitiveness of the goods i.e., foreign countries can purchase more quantity of goods and services with the same amount of foreign currency from the domestic country. As a result, exports of the domestic country rise.

Question. Explain the meaning of Managed Floating Exchange Rate.
Answer: Managed Floating Exchange Rate : Managed floating is a tool employed by the Central Bank to restore the value of the country’s currency (in relation to other currencies) within the desired limits, even when exchange rate is determined by the market forces of demand and supply. It is a mixture of Flexible exchange rate (determined by market forces) and fixed change rate (managed by Central bank).

Question. Recently Government of India has doubled the import duty on gold. What impact is it likely to have on foreign exchange rate and how ?
Answer: Increased import duty on gold will make imports of gold costly. It will reduce demand for import of gold and consequently of foreign exchange. Supply of foreign exchange remaining unchanged price of foreign exchange is likely to fall.

Question. Explain where there is an inverse relationship between price of Foreign Currency and its demand. 
Answer: It is true that there is an inverse relationship between price of foreign currency and its demand.
Suppose, foreign exchange rate falls, it means that imports, etc., have become cheaper because people now have to pay less for imports. As a result, demand for imports will rise. This leads to increase in demand for foreign exchange.
Similarly, if exchange rate rises, imports become costly for the domestic consumers. This reduces demand for imports causing fall in demands for foreign exchange.

Question. Visits to foreign countries for sight seeing etc., by the people of India is on the rise. What will be its likely impact on foreign exchange rate and how ?
Answer: It will raise demand for foreign exchange for spending the same in foreign countries. Supply of foreign exchange remaining unchanged, exchange rate is likely to rise.

Question. How is exchange rate determined in the Foreign Exchange Market ? Explain. 
Answer:It is determined by the forces of demand and supply of foreign exchange. The price and demand for foreign exchange are inversely related and supply and price of foreign exchange are directly related. The price at which demand and supply are equal is the price determined by the market.

Question. Why foreign exchange rate and supply of foreign exchange are directly related ? Explain.
Answer: When foreign exchange rate rises, domestic goods become cheaper for foreign buyers. This raises demand for exports causing rise in supply of foreign exchange (when foreign exchange rate falls, domestic goods become costlier for foreign buyers decreasing demand for the exports causing fall in supply of foreign exchange.) (Explanation based on anyone, rise or fall in foreign exchange rate, is enough to attract full credit.

Question. ‘Devaluation and Depreciation of currency are one and the same thing’. Do you agree ? How do they affect the exports of a country ?
Answer: Devaluation is the fall in the value of domestic currency in relation to foreign currency as planned by the government in a situation when exchange rate is not determined by the forces of demand and supply, but is fixed by the government of different countries. Whereas, Depreciation is the fall in the value of domestic currency in relation to foreign currency in a situation when exchange rate is determined by the forces of demand and supply in the international money market. 2 As a general phenomena, any depreciation/devaluation of currency may result into increase in exports of the goods and services from the country since it would increase the global competitiveness of the goods.

Question. Describe any three sources of demand for foreign exchange. 
Answer:
(i) For imports.
(ii) For investment in other countries.
(iii) For foreign travelling, etc.

Question. Explain why there is an increase in demand for Foreign Currency when its price falls.
Answer: There is an inverse relationship between price of foreign currency and its demand. Suppose foreign exchange rate falls, it means that imports have become cheaper because people now have to pay less for imports. As a result, demand for imports will rise. This leads to increase in demand for foreign exchange.

Question. State any three sources of supply of foreign exchange. 
Answer: (i) Exporters (ii) Foreign investors (iii) Foreign tourists, etc.
Following factors contribute to the flow of foreign exchange into the country :
(i) Purchases of domestic goods by the foreigners.
(ii) Foreign direct investment as well as portfolio investment in home country.
(iii) Speculative purchases of foreign exchange.
(iv) Transfer of foreign exchange by the residents of the country abroad.

Question. What is “Appreciation” of domestic currency ? What is its likely effect on exports and how ?
OR
Explain the effect of appreciation of domestic currency on exports. 
Answer: Appreciation of domestic currency occurs when market determined exchange rate falls. It signifies that foreign buyers will be able to buy less from one unit of currency. This makes exports costlier for the foreign buyers. As a result, exports are likely to decline. 

Question. How does giving incentives for exports influence foreign exchange rate ? Explain.
Answer: Incentives for exports are aimed at increasing exports. Increase in exports will bring more foreign exchange into the country. Demand for foreign exchange remaining unchanged, exchange rate is likely to fall.

Question. Explain why there is an increase in supply of Foreign Currency when its price rises.
Answer: There is a direct relation between foreign exchange rate and supply of foreign exchange. When price of foreign exchange rises its supply also rises as the exports from domestic market become cheaper for them but imports become expensive for us.

Question. Foreign Exchange Rate in India is on the rise recently. What impact is it likely to have on exports and how ? 
OR
Explain the effect of rise in price of foreign currency on exports.
Answer: Rise in foreign exchange rate means that one unit of foreign currency is worth more rupees than earlier. So one unit of foreign currency can now buy more goods and services from India. It makes Indian exports cheaper to the foreign buyers. This is likely to increase exports.

Question. When Foreign Exchange Rate in a country is on the rise, what impact is it likely to have on imports and how ?
OR
Foreign exchange rates have risen considerably in a country. What is its likely impact on imports of that country and why?
Answer: When foreign exchange rate rises, it makes the countries imports costly. The importers have to pay a higher price in terms of domestic currency for the goods and services imported. This may reduce demand for imports.

Question. In India, exchange rate of U. S. dollar has risen considerably. What is its likely impact on Indian Exports and why ?
Answer: Exchange rate of U.S. dollar has risen considerably, this will raise Indian export because depreciation of the rupee will raise the cost of buying (U.S.) foreign goods and make domestic (Indian) goods less costly.

Long Answer Type Questions

Question. Discuss briefly the meanings of: (i) Fixed Exchange Rate (ii) Flexible Exchange Rate (iii) Managed Floating Exchange Rate
Answer: Fixed Exchange Rate : is the exchange rate determined by the government for conversion of domestic currency into foreign currency. 2 Flexible Exchange Rate : is the rate exchange which is determined by the market forces of demand and supply in the foreign exchange market. 2 Managed Floating Exchange Rate : Floating rate influenced by buying and selling foreign exchange by the central bank in the foreign exchange market.

Question. Distinguish between the fixed exchange rate and floating exchange rate. If exchange rate falls, explain its effects on exports and imports. 
Answer: Fixed Exchange Rate : Fixed rate of exchange is a rate fixed and determined by the government of a country and government alone changes it. Flexible Exchange Rate : Flexible rate of exchange is that rate which is determined by the demand for and supply of different currencies in the foreign exchange market. If exchange rate falls, foreign goods become cheaper. This raises imports. If exchange rate falls, domestic goods become dearer to the foreign buyers. This reduces exports.

Question. (i) In which sub-account and on which side of Balance of Payments Account will foreign investments in India be recorded ? Give reasons. (ii) What will be the effect of foreign investments in India on exchange rate? Explain.
Answer: (i) Foreign investments will be recorded in the Capital Account of the BOP Account because these give rise to foreign exchange liabilities.
Foreign investment will be recorded on the credit side because these bring in foreign exchange to the economy. 2 (ii) Foreign investment add to supply of foreign exchange. Demand remaining unchanged, it brings downward influence on exchange rate.
(i) Foreign investments in India will be recorded in the Capital Account of Balance of Payments Account as it leads to decrease in the asset of the residents of the country to the rest of the world. It is recorded on the credit side of Balance of Payments Account as it leads to inflow of foreign exchange. 3 (ii) Foreign investment in India will lead to increase in the supply of foreign exchange. If the supply of foreign exchange increases in the foreign exchange market, it will lead to a rightward shift in the supply curve from SS to S1S1 and exchange rate will fall from R to R1.

Question. Explain the distinction between the flexible exchange rate and the managed floating exchange rate.
Answer: Flexible Exchange Rate : The system of exchange rate in which rate of exchange is determined by forces of demand and supply of foreign exchange market is called Flexible Exchange Rate System. Here, value of currency is allowed to fluctuate or adjust freely according to change in demand and supply of foreign exchange. There is no official intervention in foreign exchange market. Under this system, the central bank, without intervention, allows the exchange rate to adjust so as to equate the supply and demand for foreign currency. In India, it is flexible exchange rate which is being determined. The foreign exchange market is busy at all times by changes in the exchange rate. Managed Floating : This refers to a system of gradual adjustments in the exchange rate deliberately made by a central bank to influence the value of its own currency in relation to other currencies. This is done to save its own currency from short-term volatility in exchange rate caused by economic shocks and speculation. Thus, central bank intervenes to smoothen out ups and downs in the exchange rate of home currency to its own advantage. When central bank manipulates floating exchange rate to disadvantage of other countries, it is termed as dirty floating. However, central banks have no fixed times for intervention but have a set of rules and guidelines for this purpose.

Question. 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 refers to any currency other than the domestic currency. Foreign exchange rate is the rate at which one currency can be converted into another currency. Suppose, Foreign Exchange Rate falls, it means that imports, etc., have become cheaper because people now have to pay less for imports. As a result, demand for imports, etc., rises. This leads to increase in demand for foreign exchange. Similarly, if exchange rate rises, the demand for foreign exchange falls.

Question. Indian investors borrow from abroad. Answer the following :
(i) In which sub-account and on which side of the Balance of Payments Account will this borrowing be recorded ? Give reason. (ii) Explain what is the impact of this borrowing on exchange rate. 
Answer:
(i) Borrowings from abroad are recorded in the Capital Account of the BOP because these give rise to foreign exchange liabilities. 
These are recorded on the credit side because these bring foreign exchange into the country. 
(ii) Borrowing from abroad raise supply of foreign exchange. Demand for foreign exchange remaining unchanged, exchange rate is likely to fall.

Question. Explain three sources of demand for foreign exchange and three sources of supply of foreign exchange.
Answer: Sources of demand for foreign exchange :
(i) Imports
(ii) Interest payments on loans from abroad.
(iii) Investment abroad.
(iv) Explanation : These are sources of demand because these lead to outflow of foreign exchange.
Sources of supply for foreign exchange :
(i) Exports (ii) Interest received on loans to abroad.
(iii) Investment from abroad.
(iv) Any other.
Explanation : these are sources of supply because these lead to inflow of foreign exchange.
Sources of demand for foreign exchange:
(i) Import of Goods and Services : Foreign Exchange is demanded to make the payment for import of goods and services.
(ii) Tourism : Foreign exchange is needed to meet
expenditure incurred in foreign tours.
(iii) Unilateral Transfers sent abroad : Foreign exchange is required for making unilateral transfers like sending gifts to other countries.
(iv) Purchase of Assets in Foreign Countries : It is demanded to make payment for purchase of assets, like land, shares, bonds, etc. in the foreign countries.
(v) Speculation : Demand for foreign exchange arises when people want to make gains -from appreciation of currency. Sources of supply for foreign exchange :
(i) Export of Goods and Services : Supply of foreign exchange comes through export of goods and services.
(ii) Foreign Investment : The amount, which foreigners invest in the home country, increases the supply of foreign exchange.
(iii) Remittances (Unilateral transfers) from abroad : Supply of foreign exchange increases in the form of gifts and other remittances from abroad.
(iv) Speculation : Supply of foreign exchange comes from those who want to speculate on the value of foreign exchange.

Question. (i) Explain the impact of rise in exchange rate on national income.
(ii) Explain the concept of ‘deficit’ in balance of payments.
Answer: (i) Rise in foreign exchange rate means appreciation in the value of foreign currency in relation to the domestic currency, i.e. one unit of foreign currency can buy more goods and services from India. If makes exports cheaper to foreign buyers and imports costlier to Indian buyers. As a result exports rise and imports fall leading to rise in net exports. A rise in net exports may lead to rise in national income. 
(ii) A deficit in Balance of Payment occurs when during the year autonomous inflows of foreign exchange fall short of autonomous outflows of foreign exchange. Autonomous transactions are the transactions which are independent of other transactions in the Balance of Payments.

Question. Explain by giving examples, the distinction between depreciation and devaluation of domestic currency. 
Answer: Depreciation of domestic currency refers to fall in the value of domestic currency in terms of foreign currency caused by rise in foreign exchange rate in the foreign exchange market. Devaluation refers to fall in the value of domestic currency due to deliberate increase in foreign exchange rate by the government which follows fixed exchange rate system. Example: Suppose market rate of one US dollar rises from ₹ 60 to ₹ 65, the domestic buyers will now have to pay more for imports. It means one rupee can now buy less imports than before depreciation or devaluation.

Question. Indian investors lend abroad. Answer the following questions : (i) In which sub-account and on which side of the Balance of Payments Account such lending is recorded ? Give reasons. (ii) Explain the impact of these lendings on Market Exchange Rate.
Answer: (i) Indians lending abroad is recorded in Capital Account of BOP Account because it leads to creation of foreign exchange assets. It is recorded on the debit side because it leads to outflow of foreign exchange. (ii) Lending abroad increases demand for foreign exchange. Supply of foreign exchange remains unchanged, exchange rate may rise.
(i) In Capital Account, and on debit side of BOP, the lending of Indian investors to abroad will be recorded. Indian investors lending abroad cause an outflow of foreign exchange from the country. Thus, it is recorded as negative item in the Capital Account of BOP. (ii) Lending to abroad by Indian investors will increase the demand foreign exchange. This would shift the demand curve from DD to D’D’. With the shift in demand curve, the new equilibrium is established at point E’, where the exchange rate rises from OR to OR’.

Question. (i) According to recent media reports : ‘USA has accused China of currency devaluation to promote its exports’ In the light of the given media report comment, how exports can be promoted through the currency devaluation? Discuss their importance in Balance of Payments. 
Answer: (i) USA has a valid point of argument as devaluation of a currency encourages exports of a country. As exported goods become cheaper in the international market giving a competitive edge for the goods of domestic country (China). Devaluation of the value of domestic currency promotes the exports of the country and may adversely impact the production and sale of importing country.

Question. “Improvement in exchange rate of the country’s currency is always beneficial for the countries like India.” Justify.
Answer: In developing countries like India, improvement in the exchange rate implies increase in the value of Indian currency in reference to foreign currency (Say, US dollar) and less rupees are to be paid for a dollar than before. It points to the relative strength of the Indian rupee in the international market. But it has adverse impact also as it is not beneficial for Indian Exports. It would mean that US now can buy less Indian goods for a dollar, than before, which might cut US demand for Indian goods. So, it can be concluded that improvement in exchange rate of the country’s currency is beneficial but not always.