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Class 12 Economics Chapter 6 Open Economy Macroeconomics
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Open Economy Macroeconomics
Chapter: 6
PART – A
VERY SHORT TYPE QUESTIONS 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:
Total foreign trade as a proportion of GDP is a common measure of the degree of openness of an economy.
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. Write true or false:
There exists a single currency at international level issued by a central authority.
Ans : True.
6. 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 period.
7. What are the two main accounts of the balance of payments?
Ans : (i) Current Account & (ii) Capital Account.
8. Can a country have a trade deficit and current account surplus simultaneously?
Ans : Yes.
9. 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.
10. What is transfer payment?
Ans : If the refers to those earnings and spending of the country, which occurred without demanding anything in return, for example, grants, aids, gifts, etc.
11. Define a foreign exchange market.
Ans : The place where buying and selling of foreign currencies are take place is known as foreign exchange market.
12. Mention any one of the major participants of foreign exchange market.
Ans : Foreign Exchange Brokers of Agents.
13. 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.
14. “A rupee – dollar exchange rate is Rs. 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 (45).
15. 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.
16. What is real exchange rate?
Ans : RER is exchange rate which is based on constant prices to dominate the effect of price changes.
17. Y = C + I + G + NX. – In this equation what does NX refer to?
Ans : (NX = Net Exports).
18. Write true or false:
A positive NX implies a trade surplus.
Ans : True.
19. 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.
20. Name the theory of international exchange which holds that the price of similar goods in different countries is the same.
Ans : Real exchange rate.
21. 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.
22. State two sources of supply of foreign currency.
Ans : Two sources are:
(i) Exporters (ii) Foreign Investment.
23. Write economic term of the following:
NEER
REER
Ans : Nominal effective exchange rates (NEER)
Real effective exchange rates (REER)
24. Write true or false:
In the real exchange rate is equal to one, currencies are at purchasing power parity.
Ans : True
25. What is balance of payment equilibrium?
Ans : It means there is neither deficit nor surplus in the BOP accounts.
26. What constitute the third element in the BOP?
Ans : Autonomous and Accommodating Items of BOP
27. Give one example of accommodating capital flow. 2016
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 BOP, then such a transaction should be labelled as autonomous.
B. SHORT ANSWER QUESTION TYPE – II: (MRKS: 3)
1. Give the meaning of product market linkage, financial market linkage and factor market linkage in the context of n 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 similarly the labour force is also open up to work where they intend to.
2. 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.
3. What is devaluation of currency?
Ans : It refers to a reduction in the external value of a currency in terms of other currencies. Under it, there is no change in the internal purchasing power of the currency.
4. 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.
5. 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.
6. Explain the Bretton 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 doller at $ 35 per ounce of gold.
7. Suppose it takes 45 rupees to buy one US dollar ($1) If the price of a cup of coffe in India Rs. 10 and in US is $ 0.5, what will be the real exchange rate?
Ans : We know that –
8. 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
9. Clarify the meaning of purchasing power parity.
Ans : See Q. No. 15(Very Short Type).
10. Explain the concept of transfer payments.
Ans : See Q. No. 10(Very Short Type).
11. 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 maximization, 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.
12. 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 : 
Total new income = additional sum x K
= (500 x 10) crores = 5000 crores
C. SHORT ANSWER QUESTIONS TYPE-I: (MARKS: 4)
1. 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.
2. 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.
3. Distinguish between autonomous and accommodating transactions and balance of payment.
Ans : There are two flows of items that take place 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 maximization, 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 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.
4. 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 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 un required transfer: Unilateral transfer 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 transaction: 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.
5. 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.
6. 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.
7. 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.
8. Explain the significance of income in determining the exchange rate.
Ans : Change in income also affect the exchange rate, when income increases, consumer spend more on imported goods. So the demand curve for foreign exchange shifts to the right. In this case, the domestic currency depreciates in value. If income also increases and the supply curve for foreign exchange shifts to the right indicating increase in supply for foreign exchange. In general, other things remaining the same, if a country’s imparts grow faster than its experts its currency would depreciate because its demand curve for foreign currency shifts faster than its supply curve.
9. What is the role of the central bank in case of flexible exchange rates and managed floating 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. There 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.
D. LONG ANSWER QUESTIONS TYPE: (MARKS: 5)
1. 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 re-established 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.
2. 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 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 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. Pound 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.
3. 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 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.
4. 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 for which suitable substitutes exist, demand elasticities for imports might be high.
The supply of foreign exchange in this case in 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.
5. Suppose in an economy, the consumption function is given as C = 60 + 0.7 Y ; government expenditure (G) = 50 ; Export (X) = 80; government tax revenue is (T) = 60 and import (M) = 50 + 0.10 Y. Now,
(i) find out equilibrium level of income in that economy.
(ii) find out the net export at the equilibrium income.
(iii) find out what happens to equilibrium income and the net export balance when the government purchases increase from 50 to 60.
Ans : Given, C=30+0.7Y G=50 X=80 T=60
M=50_0.10Y
(i) Equilibrium income
Y=C+G+X-M = (60 + 0.7Y) + 50 + 80 – (50 + 0.10Y)
= 60 + 0.7Y + 50 + 80 – 50 – 0.10Y
⟹ Y-007Y + 0.10Y=60+50+80-50 ⟹ Y(1 – 0.7 + 0.10)= 140
∴ Y = 350
Again, given, T = 60
∴ Equilibrium income.
Y Y + T = 350 + 60 = 410
(ii) Net Export(NE) = X – M = 80 – (50+0.10Y) = -11
(iii) Given,govt. purchase increases from 50to 60.
∴ The new equilibrium income is
Y = 410+33.33 = 443.33
6. Explain the following concepts:
(a) Real Exchange Rate
(b) Nominal Exchange Rate
(c) Real Effective Exchange Rate.
Ans : (a) 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 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: 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. 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 transactions.
(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.
9. 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 foreigner 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 import 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.
10. What is transfer payment?
Ans : One way payment of money for which no money, good, or service is received in exchange. Government 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.
11. What is a Deficit Budget? Why a deficit budget is considered beneficial than a surplus budget for a developing economy?
Ans : A government budget is said to be deficit budget if the estimated government expenditure exceeds the expected government revenue in a particular financial year. This type of budget is best suited for developing economies such as India. Especially helpful as times of recession, a deficit budget helps generate additional demand and boast the rate of economic growth. Here, the government incurs the excessive expenditure to improve the employment rate. This results in an increase in demand for goods and services which helps in reviving the economy.
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