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Class 12 Economics Chapter 5 Open Economy
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Open Economy
Chapter: 5
| PART – (A) INTRODUCTORY MACROECONOMICS |
(A) Very Short Types Question & Answers:
1. When the import function is given as M = 50 + 0.4 Y, what will be the marginal propensity to import?
Ans: It is equal to 0.4.
2. Define an open economy.
Ans: The economy which is open for trade to the world community is known as open economy.
3. Write true or false:
(a) Total foreign trade as a proportion of GDP is a common measure of the degree of openness of an economy.
Ans: True.
(b) There exists a single currency at international level issued by a central authority.
Ans: True.
(c) In the real exchange rate is equal tone, currencies are at purchasing power parity.
Ans: True.
4. In 2006-07, India’s foreign trade was 34.9 percent of GDP; it was 20.9 percent in 1985-86. – On the basis of this statement state in which year was India’s economy more open?
Ans: 2006-07.
5. What is balance of payments?
Ans: Balance of payment is a systematic record of all economic transactions between the residents of a country and the rest of the world during a certain fixed time period.
6. What are the two main accounts of the balance of payments?
Ans: (i) Current Account.
(ii) Capital Account.
7. Can a country have a trade deficit and current account surplus simultaneously?
Ans: Yes.
8. What is invisible trade?
Ans: All types of exports and imports of services (non-factor services such as banking, insurance, transportation etc. and factor services) are called invisible items of trade.
9. What is transfer payment?
Ans: If the refers to those earnings and spendings of the country, which occurred without demanding any thing in return, for example, grants, aids, gifts, etc.
10. Define a foreign exchange market.
Ans: The place where buying and selling of foreign currencies are take place is known as foreign exchange market.
11. Mention any one of the major participants of foreign exchange market.
Ans: Foreign Exchange Brokers or Agents.
12. Define foreign exchange rate.
Ans: The rate at which currency of one country is converted into the currency of another country is called foreign exchange rate.
13. “A rupee – dollar exchange rate is ₹ 45.” — What does the above statement imply?
Ans: It means that to get one us dollar (1$) we have to pay Indian rupees of forty five (Σ 45).
14. What is purchasing power parity?
Ans: Under fixed exchange rate system, value of currency is fixed in terms of other currency or in terms of gold. This value is known as the parity value of the currency.
15. What is real exchange rate?
Ans: RER is exchange rate which is based on constant prices to dominate the effect of price changes.
16. Y = C + I + G + NX. – In this equation what does NX refer to?
Ans: (NX = Net Exports).
17. Choose the correct word:
The decrease in the price of domestic currency under pegged exchange rates through official action is called _________. (Depreciation/Devaluation? Revaluation)
Ans: Devaluation.
18. Name the theory of international exchange which holds that the price of similar goods in different countries is the same.
Ans: Real exchange rate.
19. What is Bilateral Nominal Exchange rate?
Ans: Bilateral nominal exchange rate is simply the price of one currency in terms of the number of units of some other currency.
20. State two sources of supply of foreign currency.
Ans: Two sources are:
(i) Exporters.
(ii) Foreign Investment.
21. Write economic term of the following:
(a) NEER.
Ans: Nominal effective exchange rates (NEER).
(b) REER.
Ans: Real effective exchange rates (REER).
22. What is balance of payment equilibrium?
Ans: It means there is neither deficit nor surplus in the BOP accounts.
23. What constitute the third element in the BOP?
Ans: Autonomous and Accommodating Items of BOP.
24. Give one example of accommodating capital flow.
Ans: For example a short term capital movement could be a reaction to difference in interest rates between two countries. If those interest rates are largely determined by influences other than the BOP, then such a transaction should be labelled as autonomous.
(B) Short Type Questions & Answers:
1. Explain the significance of interest rates in determining exchange rate.
Ans: In a managed floating system, foreign exchange rate is determined by market forces. However, the central bank need to intervene in the system in order to restrict the fluctuations in the exchange rate within certain limits. The aim is to keep exchange rate close to desired target values. For this, central bank maintains reserves of foreign exchange to ensure that the exchange rate stays within the targeted value.
2. Distinguish between flexible foreign exchange rate and fixed foreign exchange rate in the content of foreign trade.
Ans: (i) Fixed exchange rates are officially declared by the government and remain fixed, while flexible exchange rates are determined by the forces of demand and supply in the foreign exchange market.
(ii) Under fixed exchange rate, central banks stand ready to purchase and sell their currencies at a fixed price, while under flexible exchange rates, central banks without intervention permit the exchange rate to be freely determined in the foreign exchange market.
3. What are the advantages of a fixed exchange rate?
Ans: Some advantages of a fixed exchange rate system include:
(a) Stability: Fixed exchange rates provide stability and predictability in international trade and investments, as the exchange rate remains constant. It reduces uncertainty and exchange rate risk for businesses and investors.
(b) Inflation Control: A fixed exchange rate can help control inflation, as it restricts the ability of the central bank to create excessive money supply. It imposes discipline on monetary policy and promotes price stability.
(c) Trade Facilitation: Fixed exchange rates promote trade by eliminating currency fluctuations. It simplifies pricing, invoicing, and transactions for exporters and importers, reducing transaction costs and facilitating international trade.
4. What are the challenges of a fixed exchange rate?
Ans: Some challenges of a fixed exchange rate system include:
(a) Limited Monetary Policy Autonomy: Under a fixed exchange rate, the central bank’s ability to independently pursue monetary policy objectives is constrained. It must prioritise maintaining the fixed rate, which may limit its flexibility in responding to domestic economic conditions.
(b) External Shocks: Fixed exchange rates can make economies vulnerable to external shocks, such as changes in the value of the reference currency or global economic imbalances. If the fixed rate becomes misaligned with the market equilibrium rate, it can lead to economic instability.
(c) Speculative Attacks: Speculators can exploit perceived misalignments in the fixed exchange rate system by betting against the currency, leading to speculative attacks and potential currency crises.
5. Define spot and forward exchange rate.
Ans: The spot exchange range is simply the current exchange rate as opposed to the forward exchange rate. Forward exchange rate essentially refers to an exchange rate that is quoted and traded today but for delivery and payment on a set future date.
6. What is a managed floating exchange rate?
Ans: A managed floating exchange rate, also known as a managed float or dirty float, is a flexible exchange rate system in which the value of a country’s currency is determined by market forces but is subject to intervention and influence by the central bank or monetary authority.
7. What are examples of countries with managed floating exchange rates?
Ans: Many countries, including major economies like the United States, Japan, and the European Union, operate under a managed floating exchange rate system. The degree and frequency of intervention may vary among countries depending on their specific policy objectives and market conditions.
8. What is a managed floating exchange rate?
Ans: A managed floating exchange rate, also known as a managed float or dirty float, is a flexible exchange rate system in which the value of a country’s currency is determined by market forces but is subject to intervention and influence by the central bank or monetary authority.
9. What are examples of countries with managed floating exchange rates?
Ans: Many countries, including major economies like the United States, Japan, and the European Union, operate under a managed floating exchange rate system. The degree and frequency of intervention may vary among countries depending on their specific policy objectives and market conditions.
10. What influences the exchange rate under a fixed exchange rate system?
Ans: Under a fixed exchange rate system, the exchange rate is influenced by the actions of the government or central bank. The authorities maintain the fixed rate by intervening in the foreign exchange market through buying or selling their currency. By adjusting the supply of their currency, they aim to balance the demand and maintain the fixed rate.
11. What influences the exchange rate under a flexible exchange rate system?
Ans: Under a flexible exchange rate system, the exchange rate is influenced by market factors. Supply and demand dynamics in the foreign exchange market, including trade flows, capital flows, economic indicators, interest rate differentials, investor sentiment, and geopolitical events, impact the exchange rate. Market participants, such as banks, corporations, investors, and speculators, actively trade currencies, contributing to exchange rate movements.
12. What is transfer payment?
Ans: One way payment of money for which no money, good, or service is received in exchange. Governments use such payments as means of income redistribution by giving out money under social welfare programs such as social security, old age or disability pension etc.
13. What is a fixed exchange rate?
Ans: A fixed exchange rate is a system in which the value of a country’s currency is pegged or fixed to the value of another currency or a basket of currencies. Under this system, the exchange rate remains relatively constant and does not fluctuate freely based on market forces like supply and demand.
14. Give the meanings of product market linkage, financial market linkage and factor market linkage in the context of an open economy.
Ans: Product market linkage means, choice in between domestic goods and foreign goods. Financial market linkage means the preferences to invest in between domestic assets and foreign assets.
Factor market linkage means to make choice to operate the firms or industry in the domestic market or foreign market and similarly the labour force is also open up to work where they intend to.
15. What is pegged exchange rate system?
Ans: According to crawling peg system, a country specifies a parity value for its currency and permits the exchange rate to fluctuate within a margin of one percent above or below the parity value. There is a ceiling and floor limit so that it can provide some discipline on the part of monetary authorities.
16. Write two merits of fixed exchange rate.
Ans: The two merits of fixed exchange rate are:
(a) It ensures stability in foreign exchange that encourages foreign trade.
(b) It prevents capital outflow.
17. What is gold standard?
Ans: Under gold standard, each currency value was defined in terms of gold and hence, the exchange rate was fixed according to the gold value of currencies that have to be exchanged.
18. Explain what is meant by the managed floating exchange rate system.
Ans: It 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. This system is hybrid or combination of fixed and flexible exchange rates. The exchange rate is managed by government, but the intervention is discretionary on the part of monetary authority.
19. Explain the Bretton woods system.
Ans: According to the Bretton woods Agreement, after world war II, exchange rates between countries were set or paged in terms of gold or VS dollar at $ 35 per ounce of gold.
20. Distinguish between balance of trade and balance of payments.
Ans: The balance of trade and balance of payments distinguish between are:
(i) In the balance of trade, only the exports and imports of visible goods are included, while balance of payments includes both visible and invisible transactions. It also includes unilateral transfers and capital transaction.
(ii) Balance of trade account is a part of the current account of the balance of payment, while balance of payment account considers both current and capital accounts.
(iii) There may be surplus or deficit in the balance of trade account, while balance of payment is always balance in accounting sense.
21. What are the challenges of a managed floating exchange rate?
Ans: Some challenges of a managed floating exchange rate system include:
(a) Exchange Rate Management: Central banks need to monitor and manage the exchange rate to avoid excessive volatility or misalignments that can impact trade, investment, and inflation.
(b) Policy Coordination: Maintaining a stable exchange rate under a managed float may require coordination between fiscal and monetary policies to avoid conflicting objectives and ensure consistent policy signals.
(c) Market Expectations: Market participants’ expectations and perceptions about future exchange rate movements can influence capital flows and exchange rate dynamics, making it challenging to manage the exchange rate effectively.
22. What are the demerits of a fixed exchange rate system?
Ans: Some demerits of a fixed exchange rate system include:
(a) Limited Monetary Policy Autonomy: Under a fixed exchange rate system, the central bank’s ability to independently pursue monetary policy objectives is restricted. The focus shifts from domestic objectives to maintaining the fixed rate, which can limit the flexibility to respond to domestic economic conditions.
(b) External Shocks and Imbalances: Fixed exchange rates can make economies more vulnerable to external shocks, such as changes in the value of the reference currency or global economic imbalances. Misalignments between the fixed rate and economic fundamentals can result in imbalances and economic instability.
(c) Speculative Attacks and Currency Crises: Fixed exchange rate systems can be prone to speculative attacks and currency crises. Speculators may try to exploit perceived misalignments, leading to unsustainable pressures on the currency and potential economic instability.
23. What are the demerits of a flexible exchange rate system?
Ans: Some demerits of a flexible exchange rate system include:
(a) Exchange Rate Volatility: Flexible exchange rates can lead to higher exchange rate volatility, which can create uncertainty for businesses, investors, and individuals engaged in international trade or investments. This volatility can complicate planning, pricing, and risk management.
(b) Speculation and Market Sentiments: Market participants’ expectations and sentiments can influence exchange rate movements, sometimes leading to excessive volatility or speculative activities. These factors can result in misalignments between the exchange rate and economic fundamentals.
(c) Trade Competitiveness Challenges: Flexible exchange rates can affect a country’s trade competitiveness. If the currency appreciates significantly, it can make exports more expensive and imports cheaper, potentially impacting export-oriented industries and trade balances.
24. What are the advantages of a managed floating exchange rate?
Ans: Some advantages of a managed floating exchange rate system include:
(a) Flexibility: Managed floating allows the exchange rate to adjust based on market conditions, which can help absorb shocks and maintain external competitiveness.
(b) Monetary Policy Autonomy: Compared to a fixed exchange rate system, a managed float provides greater flexibility for the central bank to conduct independent monetary policy to address domestic economic conditions.
(c) Reduced Speculative Attacks: The ability of the central bank to intervene in the foreign exchange market can help mitigate speculative attacks and excessive exchange rate fluctuations.
25. What are the challenges of a managed floating exchange rate?
Ans: Some challenges of a managed floating exchange rate system include:
(a) Exchange Rate Management: Central banks need to monitor and manage the exchange rate to avoid excessive volatility or misalignments that can impact trade, investment, and inflation.
(b) Policy Coordination: Maintaining a stable exchange rate under a managed float may require coordination between fiscal and monetary policies to avoid conflicting objectives and ensure consistent policy signals.
(c) Market Expectations: Market participants’ expectations and perceptions about future exchange rate movements can influence capital flows and exchange rate dynamics, making it challenging to manage the exchange rate effectively.
26. What are the merits of a flexible exchange rate system?
Ans: Some merits of a flexible exchange rate system include:
(a) Automatic Adjustments: Flexible exchange rates allow for automatic adjustments in response to changing economic conditions, including trade imbalances, inflation differentials, and capital flows. This helps maintain external competitiveness and equilibrium in the foreign exchange market.
(b) Monetary Policy Autonomy: Countries with flexible exchange rates have greater monetary policy autonomy. They can independently adjust interest rates and implement domestic policy measures to address inflation, unemployment, and other economic objectives without constraints imposed by maintaining a fixed exchange rate.
(c) Absorbing Shocks: Flexible exchange rates provide a natural shock absorber, allowing the currency to adjust in response to external shocks such as changes in commodity prices, economic recessions, or financial crises. This flexibility can help mitigate the impact on the economy.
27. Is the trade deficit harmful to the growth of an economy? – Explain.
Ans: Yes, because it may leads to:
(a) Low rate of economic development.
(b) Fall in foreign exchange reserves.
(c) Exploitations of the resources of that particular country.
(d) Low amount of production and it may leads to low income and employment generation.
28. Distinguish between depreciation of money and appreciation of money.
Ans: Depreciation of money implies a fall in the external value of money. When a unit of domestic currency exchanges for lesser units of a foreign currency the domestic currency is said to have depreciated.
Appreciation of money means a rise in the external value of a currency.
29. What is the role of the central bank in case of flexible exchange rates and managed floating exchange rates? Explain briefly.
Ans: In a system of flexible exchange rates the exchange rate is determined freely by the market forces of demand and supply. These is no intervention by the central banks. Hence there are no official reserve transactions. A foreign exchange market like other competitive markets, leads to an equilibrium exchange rate at which quantity demanded equals quantity supplied of foreign exchange for simplicity, we presume that India and America are the only two countries in the world. So there is only one exchange rate is to be determined.
30. Suppose it takes 45 rupees to buy one US dollar ($1) If the price of a cup of coffee in India is ₹ 10 and in US is $ 0.5, what will be the real exchange rate?
Ans: We know that —
Real Exchange Rate = Money Exchange Rate × Inflation in Foreign Economy/Inflation in domestic economy
= 45 × 0.5/10 = 2.25
31. In an open economy if the marginal propensity to consume (c) is 0.8 and the marginal propensity to import (m) is 0.2, find out the size of the income multiplier.
Ans: Given, C = 0.8
Import (m) = 0.2
∴ Income Multiplier = 1/1 – C + M = 1/1 – 0.8 + 0.2 = 1/0.4 = 2.5
32. What are “above the line” and “below the line” items in the BOP?
Ans: “Above the line” items in the BOP refer to those international economic transactions which occur due to some economic considerations such as profit maximisation, earning of interest income, below the line’ items in the BOP refers to those transactions which take place for maintaining equality in the BOP. Official reserve transactions are carried out by the government and the central banks in accordance of international economic policy.
33. The marginal propensity to consume (MPC) of an economy is 0.9 and suppose, an additional sum of Rs. 500 crores is invested in it. How much new income will be generated in the economy?
Ans: MPC = 0.9, K = 1/1-MPC = 1/1-0.9 = 1/0.1 = 10
Total new income = additional sum × K
= (500 × 10) crores = 5000 crores
34. Distinguish between an open economy and closed economy.
Ans: The economy which is open for trade to the world community is called as open economy. The financial institutions like IMF, world Bank etc. Plays an important role in the functioning of an open economy. Foreign currencies are used for export and import in an open economy.
In a closed economy there is no international trade relation with the world community. These economies does not depend upon the various financial institutions and they set there own rules for trade within a short span of area or region.
35. Explain the two main accounts of balance of payments.
Ans: (i) Current account records economic transaction relating to exchange of goods and services and unilateral transfers, while capital account record capital transactions, e.g. borrowing and lending, sale and purchase of assets.
(ii) Current account transactions are of flow nature, while capital transactions are of stock nature.
(iii) Current account transactions bring about a change in the current level of country’s income, whereas capital transactions bring about a change in the capital stock of a country.
(C) Long Type Questions & Answers:
1. Distinguish between autonomous and accommodating transactions and balance of payment.
Ans: There are two flows of items that take palace in BOP account. These are autonomous items and accommodating flows. Autonomous items in the balance of payments refer to those international economic transactions, which occur due to some economic consideration such as profit maximisation, earning of interest income. For example, if multinational corporations are making investment in India, this is done with the objective of earning income.
Accommodating items in the balance of payment refer to those transactions, which takes please for maintaining equality in the BOP. Official reserve transactions are carried out by the government and the central banks in accordance with international economic policy. These transactions are termed as accommodating transactions.
2. Describe the role of speculation in determining the flexible rate of exchange.
Ans: Balance of payment is an accounting statement that provides a systematic record of all the economic transactions, between residents of a country and the rest of the world, in a given period of time.
BOP account can be broadly classified into:
(a) Current account. and
(b) Capital account.
(a) Current account: Current account refers to an account, which records all the transactions relating to export and import of goods and services and unilateral transfers during a given period of time. The main components of current account are—
(i) Export and import of goods: A major part of transactions in foreign trade is in the form of export and import of goods. Payments for import of goods is written on the negative side (debit items) and receipts from exports is shown on the positive side (credit items).
(ii) Export and import of services: It includes a large variety of non-factor services sold and purchased by the residents of a country, to and from the rest of the world. Services are generally of 3 kinds – Shipping, Banking and Insurance.
(iii) Unilateral or unrequited transfer: Unilateral transfers include gifts, donations, personal remittances and other one way transactions. These refer to those receipts and payments, which take place without any services.
(iv) Investment income: It includes investment income in the form of interest, rent and profits.
Current account records all the actual transaction of goods and services, which affect the income, output and employment of a country. So, it shows the net income generated in the foreign sector.
(b) Capital account: Capital account of BOP records all those transactions, between the residents of a country and the rest of the world, which cause a change in the assets or liabilities of the residents of the country or the government. Capital account is used to finance deficit in current account or absorb surplus of current account.
The main components of capital accounts are:
(i) Private transactions: Private sector of the country receives short term and long term foreign loans. Receipts of such loans are recorded as positive or credit items and their repayment as negative or debit items.
(ii) Official transactions: It includes the transactions undertaken by the government with the rest of the world.
(iii) Banking Capital: It refers to capital movements in the farm of foreign exchange transactions, investments in foreign currency and securities by foreign branches, of Indian commercial and cooperative banks.
(iv) Foreign direct investment: It refers to purchase of an asset in the rest of the world such that, it gives direct control to the purchaser over the assets.
(v) Portfolio investment: It refers to purchase of an asset in the rest of the world such that, it does not give any direct control over the asset to the purchaser.
3. Explain how exchange rate is determined in a system of flexible exchange rate.
Ans: In a system of flexible exchange rates, the exchange rate is determined by the forces of market demand and supply. The monetary authority does not intensely for the purpose of influencing the exchange rate. Under a regime of freely fluctuating exchange rates, if there is an excess supply of a currency, the value of that currency in foreign exchange markets will fall. It will lead to depreciation of the exchange rate. Consequently, equilibrium will be restored in the exchange market. On the other hand storage of a currency will lead to appreciation of exchange rate, thereby leading to restoration of equilibrium in the exchange market. These market forces sperate automatically without any intervention on the part of monetary authority.
This is shown in the following figure:
In the figure, D and S are the demand and supply curve of pounds which intersect at point P and the equilibrium exchange rate is E is determined. If exchange rate rises to E₂, the quantity of pounds supplied OQ3 is more than the quantity demanded OQ₂. When pounds are in excess supply, the price of pounds will fall in the foreign exchange market. The value of pounds in terms of dollars will depreciate. Now less pounds will be supplied and more will be demanded. Ultimately, equilibrium will be reestablished at the exchange rate E. On the other hand, if the exchange rate falls to E1, the quantity of pounds demanded OQ4 is more than the quantity supplied OQ1, When there is a shortage of pounds in the foreign exchange market, the price of pounds will rise. The value of pound in terms of dollars will appreciate. The rise in the price of pounds will rise. The value of pound in terms of dollars will appreciate. The rise in the price of pounds will reduce demand for them and increase their supply. This process will continue till equilibrium exchange rate E is re established at point P.
4. Explain briefly various determinants of exchange rate under flexible exchange rate system.
Ans: The exchange rate is determined by the demand for and the supply of foreign exchange. The equilibrium exchange rate is the rate at which, the demand for foreign exchange equals to supply of foreign exchange. This demand for foreign exchange is a derived demand from pounds. It arises from import of British goods and services into the US and from capital movements from the US to Britain. The demand curve for pounds is downward sloping left to right. It implies that the lower the exchange rate on pounds, the larger will be the quantity of pounds demanded in the foreign exchange market and vice-versa. But the shape of the demand curve for foreign exchange will depend on the elasticity of demand for imports. If a country imports necessities and raw materials, we may expect the elasticity of demand for imports to be low and the quantity imported to be insensitive to price changes. If, on the other hand, the country imported luxury goods and goods for which suitable substitutes exist, demand elasticities for imports might be high.
The supply of foreign exchange in this case is the supply of pounds. It arises from the US exports of goods and services and from capital movements from the US to Britain. Pounds are offered in exchange for dollars because British holders of pounds wish to make payments in dollars. The supply curve of pounds increases the greater is the quantity of pounds supplied in the foreign exchange market. The shape of supply curve of foreign exchange will be determined by the elasticity of the supply curve. As the value of the country’s own currency increases, imports becomes relatively cheaper, and more is imported.
Given the demand and supply curves of foreign exchange, the equilibrium exchange rate is determined where the demand curve for pounds intersects the supply curve of pounds.
This is shown in the following figure:
In the figure is, DD the demand curve and SS is the supply curve of pounds that intersects at point E. The equilibrium rate is OR and OQ of foreign exchange is demanded and supplied. At OR exchange rate the US demand for pounds equals the British supply of pounds, and the foreign exchange market is cleared. At any higher rate than this, the supply of pounds would be larger than the demand for pounds so that some people who wish to convert pounds into dollars will be unable to do so. The price of pounds will fall, less pounds will be supplied and more will be demanded.
Ultimately, the equilibrium rate of the exchange will be re-established. In the figure, when the exchange rate increase to OR2, the supply of pounds R2B is greater
than R2A, the demand for pounds. With the fall in the price of pounds, the equilibrium exchange rate OR2 is again established at point E. On the contrary, at an exchange rate lower than OR2, i.e. OR1 The demand for pounds R1H is greater than the supply of pounds R1G Some people who want pounds will not be able to get there. The price of pounds so that the equilibrium exchange rate OR is re-established at point E, where the two curves DD and SS intersect.
5. Explain how the equilibrium price of a foreign currency is determined in foreign exchange market.
Ans: The exchange rate is determined by the demand for and the supply of foreign exchange. The equilibrium exchange rate is the rate at which, the demand for foreign exchange equals to supply of foreign exchange. This demand for foreign exchange is a derived demand from pounds. It arises from import of British goods and services into the US and from capital movements from the US to Britain. The demand curve for pounds is downward sloping left to right. It implies that the lower the exchange rate on pounds, the larger will be the quantity of pounds demanded in the foreign exchange market and vice-versa. But the shape of the demand curve for foreign exchange will depend on the elasticity of demand for imports. If a country imports necessities and raw materials, we may expect the elasticity of demand for imports to be low and the quantity imported to be insensitive to price changes. If, on the other hand, the country imported luxury goods and goods for which suitable substitutes exist, demand elasticities for imports might be high.
The supply of foreign exchange in this case is the supply of pounds. It arises from the US exports of goods and services and from capital movements from the US to Britain. Pounds are offered in exchange for dollars because British holders of pounds wish to make payments in dollars. The supply curve of pounds increases the greater is the quantity of pounds supplied in the foreign exchange market. The shape of supply curve of foreign exchange will be determined by the elasticity of the supply curve. As the value of the country’s own currency increases, imports becomes relatively cheaper, and more is imported.
Given the demand and supply curves of foreign exchange, the equilibrium exchange rate is determined where the demand curve for pounds intersects the supply curve of pounds.
This is shown in the following figure:
In the figure is, DD the demand curve and SS is the supply curve of pounds that intersects at point E. The equilibrium rate is OR and OQ of foreign exchange is demanded and supplied. At OR exchange rate the US demand for pounds equals the British supply of pounds, and the foreign exchange market is cleared. At any higher rate than this, the supply of pounds would be larger than the demand for pounds so that some people who wish to convert pounds into dollars will be unable to do so. The price of pounds will fall, less pounds will be supplied and more will be demanded. Ultimately, the equilibrium rate of exchange will be re-established. In the figure, when the exchange rate increase to OR2, the supply of pounds R2B is greater than R2A, the demand for pounds. With the fall in the price of pounds, the equilibrium exchange rate OR2 is again established at point E. On the contrary, at an exchange rate lower than OR2, i.e. OR1 The demand for pounds R1H is greater than the supply of pounds R1G Some people who want pounds will not be able to get there. The price of pounds so that the equilibrium exchange rate OR is re-established at point E, where the two curves DD and SS intersect.
6. Explain the following concepts:
(a) Real Exchange Rate.
Ans: Real Exchange Rate: Real exchange rate is the exchanged rate which is based on constant prices to eliminate the effect of price changes.
(b) Nominal effective exchange rate.
Ans: Nominal effective exchange rate: Nominal effective exchange rate is the measure of average relative strength of a given currency with respect to other currencies without eliminating the effect of price change.
(c) Real Effective Exchange Rate.
Ans: Real Effective Exchange Rate: We must have a measure that could eliminate the effect of price changes. This is calculated as the real effective exchange rate. Real effective exchange rate is the weighted average of the real exchange rates instead of nominal rates.
7. Explain the concept of BOP in the context of a developing economy.
Ans: Balance of payments is a summary of international transactions of a country. International transactions arise on account of flow of goods, below of services and flow of assets. Economic transactions as reflects in BOP take place between the residents of a country and residents of foreign countries. Economic transactions refers to those transactions which causes transfer of value. Balance of payments is a flow concept. All the economic flows as shown in BOP are related to a certain time period usually a financial years. The BOP accounts is a summary of international transactions of a country for a given period, that is a financial year. The balance of payments of a country is a systematic record of all transactions in goods, services and assets between the residents of a country and the residents of foreign countries during a given period of time.
8. What do you mean by disequilibrium in balance of payment (BOP)? Mention any two causes of adverse BOP of a country.
Ans: Though the credit and debit are written balanced in the balance of payment account, it may not remain balanced always. Very often, debit exceeds credit or the credit exceeds debit causing an imbalance in the balance of payment account. Such an imbalance is called the disequilibrium. Disequilibrium may take place either in the form of deficit or in the form of surplus.
Disequilibrium of Deficit arises when our receipts from the foreigners fall below our payment to foreigners. It arises when the effective demand for foreign exchange of the country exceeds its supply at a given rate of exchange. This is called an ‘unfavourable balance’.
Disequilibrium of Surplus arises when the receipts of the country exceed its payments. Such a situation arises when the effective demand for foreign exchange is less than its supply. Such a surplus disequilibrium is termed as ‘favourable balance’.
Causes of Disequilibrium in Balance of Payment:
(i) Huge development expenditure: When a backward country starts various development schemes they often needs the imports of machines, raw material etc. This raises the country’s import bill and consequently its BOP becomes adverse.
(ii) Population growth: A country with a high rate of growth of population often faces an adverse balance of payments, because the total demand for goods and services within the country can not be met out of domestic production, again necessitating imports.
9. How does a fixed exchange rate work?
Ans: A fixed exchange rate is a type of exchange rate regime where the value of a country’s currency is set and maintained at a specific rate relative to another currency, a basket of currencies, or a commodity such as gold. Here’s how a fixed exchange rate system typically works:
(a) Establishment of a Parity: The government or central bank determines the fixed exchange rate by establishing a parity between its currency and the chosen reference currency or standard. For example, a country may decide to fix its currency’s value to the US dollar at a rate of 1:1.
(b) Intervention by the Central Bank: To maintain the fixed exchange rate, the central bank intervenes in the foreign exchange market by buying or selling its own currency. If the value of the domestic currency weakens, the central bank sells its foreign currency reserves and buys its own currency to increase demand and support the fixed rate. Conversely, if the value of the domestic currency strengthens, the central bank buys foreign currency and sells its own currency to reduce demand and prevent the currency from appreciating.
(c) Currency Convertibility: Under a fixed exchange rate system, the domestic currency is generally convertible at the fixed rate. This means that residents and businesses can freely exchange their currency for the reference currency at the established rate. The central bank may provide the necessary reserves to fulfil the demand for currency conversion.
(d) Monetary Policy Coordination: To maintain the fixed exchange rate, the central bank needs to align its monetary policy with the reference currency or standard. It may need to adjust interest rates, money supply, and other monetary tools to ensure stability and prevent excessive fluctuations in the exchange rate. This coordination helps maintain confidence in the fixed exchange rate regime.
(e) Exchange Controls: In some cases, countries with fixed exchange rate systems may impose exchange controls or restrictions on capital flows to manage and stabilise the currency. These controls aim to prevent speculative activities and maintain the stability of the fixed exchange rate.
10. How does a managed floating exchange rate work?
Ans: A managed floating exchange rate, also known as a dirty float, is a type of exchange rate regime that combines elements of both fixed and flexible exchange rates. Under a managed float, the exchange rate is determined by market forces but is also subject to occasional intervention or management by the central bank. Here’s how a managed floating exchange rate system typically works:
(a) Market Determination: The exchange rate in a managed floating system is primarily determined by supply and demand in the foreign exchange market. Market forces, such as trade flows, capital flows, and investor sentiment, influence the value of the currency relative to other currencies.
(b) Central Bank Intervention: In a managed floating system, the central bank periodically intervenes in the foreign exchange market to influence the exchange rate. It may buy or sell its own currency to smooth out excessive fluctuations or to achieve specific policy objectives. For example, if the currency is experiencing rapid depreciation, the central bank may intervene by buying its own currency to increase demand and stabilise the exchange rate.
(c) Policy Objectives: The central bank’s intervention in a managed floating system is guided by certain policy objectives. These objectives can include maintaining price stability, managing inflation, promoting export competitiveness, managing capital flows, or addressing economic imbalances. The central bank’s actions aim to achieve these objectives while allowing market forces to have some influence on the exchange rate.
(d) Communication and Transparency: In a managed floating system, the central bank often communicates its exchange rate policy and intervention strategies to market participants and the public. This transparency helps provide clarity and reduces uncertainty in the foreign exchange market.
(e) Market-Based Adjustments: Unlike a fixed exchange rate system, a managed floating exchange rate allows for gradual adjustments in response to changing economic conditions. If the exchange rate deviates significantly from its desired level, the central bank may intervene to stabilise it. However, the system still allows for market forces to play a role in determining the exchange rate over the long term.
11. Outline how equilibrium exchange rate is determined in free market system.
Ans: Equilibrium rate of exchange is established at a point where the quantity demanded and quantity supplied of foreign exchange are equal. In the foreign exchange market, if disequilibrium occurs, it may lead to a situation of excess demand or excess supply. The market mechanism will drive the exchange rate back to the equilibrium level. This implies that the free market forces of demand and supply will operate in such a manner that the equilibrium rate of exchange is automatically restored.
