A. Very Short Answer Questions (Mark – 1)
1.
Define foreign exchange rate. 2015
Ans:
Foreign exchange rate is the price of one currency in terms of another
currency.
2.
Define a foreign exchange market.
Ans:
Foreign exchange market is the market where currencies of different countries
are traded for one another.
3.
Mention any one of the major participants of foreign exchange market.
Ans:
Commercial bank is the major participants of foreign exchange market.
4.
What is fixed (Pegged) exchange rate?
Ans:
Fixed exchange rate which is officially fixed in term of gold or any other
currency by the govt. Fixed exchange rate promotes international trade.
5.
What is flexible exchange rate?
Ans:
Flexible exchange rate is that rate which is determined by the forces of demand
and supply of foreign exchange.
6.
Name two sources of demand for foreign exchange.
Ans:
Two sources of demand for foreign exchange rate:
a) To
purchase goods and services from other countries by the domestic residents.
b) To
invest and purchase financial assets in some other country.
7.
Name two sources of supply for foreign exchange.
Ans:
Two sources of supply of foreign exchange are:
a)
Domestic foreign investment in the domestic
territory.
b)
Remittances by the non-residents abroad.
8.
What is real exchange rate?
Ans:
Real exchange rate is defined as price of foreign goods relative to those of
domestic goods. Real exchange rate indicates how expensive foreign goods are
relative at goods at home.
9. Define
an open economy.
Ans: An
open economy means that traders of goods and services and financial assets with
other countries.
10. What
is closed economy?
Ans:
Closed economy is one that does not trade with other nations in goods and
services and financial assets with other countries.
11.
What is Balance of Payments? 2013
Ans:
The balance of payments of a country is a systematic record of all its economic
transactions with the outside world in a given year.
12. What is
Balance of Trade?
Ans: The balance of exports and import of the product and services
is termed as Balance of Trade.
13.
What are the two main accounts of the balance of payments? 2014
Ans:
Two main accounts of the balance of payments are: Current account and Capital
account.
14.
Define current account of BOP’s.
Ans:
The current account of BOP’s means imports and exports of goods and services
and unilateral transfers.
15.
Define capital account of BOP’s.
Ans:
The capital account of BOP’s shows all the inflows and outflows of capital.
16.
What is deficient balance of trade?
Ans:
When the value of imports of a country exceeds the value of exports during a
period of time, there is a deficit in the balance of trade.
17. When the
import function is given as M = 50 + 0.4Y, what will be the marginal propensity
to import?
Ans: It is
given, M = 50 + 0.4Y \Marginal
propensity to import = 0.4
18. 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.
19.
Write true or false: There exists a single currency at international level
issued by a central authority.
Ans.
False
20.
Can a country have a trade deficit and current account surplus simultaneously?
Ans:
A country has a trade deficit and current account surplus simultaneously.
21.
What is invisible trade?
Ans:
Invisible trade refers to the services rendered by the country to other countries.
Such services consists of banking, insurance etc.
22.
“A rupee-dollar exchange rate is Rs. 65” – What does the above statement imply?
Ans:
“A rupee-dollar exchange rate is Rs. 65” that means it indicates for 1 dollar
value is Rs. 65.
23.
What is purchasing power parity?
Ans:
Purchasing power parity means the equilibrium exchange rate between two in
convertible paper currencies is determined by the equality of their purchasing
power.
24.
Y = C + 1 + G + NX – In this equation what does NX refer to?
Ans:
Here, NX refers net export. That means difference between export and import.
25.
Write true or false: A positive NX implies a trade surplus.
Ans:
True.
26.
Choose the correct word. The decreases in the price of domestic currency under
pegged exchange rates through official action is called ____
(Depreciation/Devaluation/Revaluation)
Ans:
Devaluation
27.
Name the theory of international exchange which holds that the price of similar
goods in different countries is the same.
Ans:
Purchasing Power Parity theory
28.
Write economic term of the following: NEER, REER.
Ans:
NEER means Nominal effective exchange rate. REER means Real effective exchange
rate.
29.
What is meant by currency appreciation?
Ans:
Currency appreciation means when there is a decrease in domestic currency price
of the foreign currency.
30.
Give the meaning of equilibrium foreign exchange rate?
Ans:
The equilibrium foreign exchange is that rate at which is determined by the
forces of demand and supply of foreign exchange in the foreign exchange market.
31.
What is devaluation of currency? 2012
Ans:
Devaluation means reduction in the external value of a country’s currency as a
conscious policy measures adopted by the govt. of a country. That means
domestic currency is cheaper in terms of foreign currency.
B. Questions for Marks – 3/4
Q.1. What is Fixed Exchange Rate? Mention its
merits and demerits. 2015
Ans:
Fixed exchange rate which is officially fixed in term of gold or any other
currency by the govt. Fixed exchange rate promotes international trade.
Merits of Fixed Exchange Rate: Fixed exchange
rates have the following merits:
a) Promotes
International Trade: Fixed exchange rates ensure certainty about the foreign
payments and hence help to promote international trade.
b) Promotes
International Investment: Fixed exchange rates promote international
investments. They encourage long term capital flows.
c) No
Fear of Speculation: Under fixed exchange rate system, there is no fear of
speculation on the exchange rate. Under this system. Speculative activities are
controlled and prevented by the monetary authorities.
Demerits of Foreign Exchange Rate
a) Large
Reserves of Foreign Currencies: Under the system of fixed exchange rates, large
reserves of foreign currencies are required to be maintained to avoid
devaluation.
b) Pegged
Rates are not Permanently Fixed: Fixed (pegged) exchange rates are not
permanently fixed. Countries with deficits in BOP may be forced to devalue
their currency.
c) Sacrifice
of the Objective of Full Employment and Stable Prices: Under the system of
fixed exchange rate, the objectives of full or high level of employment and
price stability at home are sacrificed at the cost of external stability.
Q.2. What is flexible exchange rate?
Mention its merits and demerits.
Ans:
Flexible exchange rate is that rate which is determined by the forces of demand
and supply of foreign exchange.
Merits of Flexible Exchange Rate: Following are the main advantages of
flexible exchange rate:
a) No
Need for Foreign Exchange Reserves: There is no need for the government to hold
foreign exchange reserves. A deficit country will simply allow its currency to
depreciate in relation to foreign currency instead of supply foreign exchange
reserves to other country to maintain a stable exchange rate.
b) Simple
in Operation: A system of flexible exchange in simple in its operation. It
eliminates the problem of overvaluation or undervaluation of currencies.
c) Autonomy
of the Domestic Monetary Policy: Under flexible exchange rate system, a country
is free to adopt independent monetary policy. Countries, therefore, are not
required to sacrifice the objectives of full employment and economic growth in
order to correct BOP disequilibrium.
d) Exchange
Controls not Required: This system does not require the use of exchange control
which is generally associated with the system of pegged rates.
Demerits of Flexible Exchange Rate
a) Unstable
Conditions: Flexible exchange rates create conditions of instability and
uncertainty in the economy. Wide fluctuations in exchange rates tend to reduce
the volume of international trade and foreign investment.
b) Inflationary
Bias: Another disadvantage of the flexible exchange rates is that they have an
inflationary impact of the economy. Whenever there is deficit in BOP, the
currency depreciates. The equilibrium exchange rate in such a situation may not
be an appropriate exchange rate.
Q.3. Distinguish between flexible foreign
exchange rate and fixed foreign exchange. 2016
Ans:
Following are the differences between flexible foreign exchange rate and fixed
foreign exchange rate in the content of foreign trade.
a) Flexible
exchange rate is determined by the forces of demand and supply of foreign
exchange. On the other hand, the fixed exchange rate is determined
automatically through the working of the economic system by the govt.
b) Under
flexible exchange rate it is free to fluctuate according to change in demand
and supply of foreign currency. On the other hand, under fixed exchange rate
system, only the govt. has the power to change it.
c) Under
flexible exchange rate, the exchange rate is frequently changed. On the other
hand, in the fixed exchange rate system, changes of exchange rate come when
there is disequilibrium in balance of payment.
d) Under
flexible exchange rate, it creates situations of instability and uncertainty.
On the other hand, under fixed exchange rate system, it ensures stability in
exchange rate.
e) Under
flexible exchange rate it eliminated the problem of overvaluation or
undervaluation of currency. On the other hand, under fixed exchange rate there
may be undervaluation or overvaluation of currency.
Q.4. Distinguish between an open economy
and closed economy.
Ans.
Differences between open and closed economy are as follows:
a) In
an open economy there are needs of foreign currency. On the other hand in a
closed economy domestic currency is needed for exchange.
b) The
aggregate demand curve of the open economy is flatter then the aggregate demand
curve of the closed economy.
c) In
an open economy, saving may not be equal to investment. On the other hand, in a
closed economy saving is always equal to investment.
d) In
an open economy, the demand for domestic goods is equal to the domestic goods
plus exports minus imports. On the other hand, in an closed economy, there are
three sources of demand for domestic goods.
Ø
Consumption,
Ø
Govt. spending,
Ø
Domestic investment.
Q.5. Distinguish between autonomous and
accommodating transactions and balance of payment. 2015
Ans:
Following are the differences between autonomous and accommodating transactions
and balance of payments.
1) The
items that are included in a particular balance are placed below the line are
called accommodating items. On the other hand the items that are put above the
line are called autonomous items.
2) Accommodating
transactions are determined by the new consequence of autonomous transaction.
On the other hand, autonomous transaction are refer those transactions which
are made independently of the state of the balance of payment. It is a record
of all economic transaction that take place between one country and the rest of
the world during an year. Balance of payments have two components – Capital
account and current account.
Q.6. Describe the role of speculation in
determining the flexible rate of exchange.
Ans:
Flexible exchange rate is determined by the forces of demand and supply of
foreign exchange. The growth of speculative activities also influences the
exchange rate. Money is important for determining the flexible exchange rate.
The increasing value of foreign currency increases the demand for money. If the
value of yen is increased then Indians will want to hold more yen. This
expectation would increase the demand for yen and this increased demand will
raise the rupee-yen exchange rates at present.
Q.7. Distinguish between balance of payment
and balance of trade. 2014,
2016
Ans:
Following are the differences between balance of payment and balance of trade:
Basis
|
Balance
of Trade
|
Balance
of Payments
|
Meaning
|
The balance of exports and import of the
product and services is termed as Balance of Trade.
|
The balance of payments of a country is a
systematic record of all its economic transactions with the outside world in
a given year.
|
Recording of transactions
|
It records transactions relating to goods
only.
|
It records transactions relating to both
goods and services.
|
Capital transfer
|
Capital transfers are not included in
balance of trade.
|
Capital transfers are included in balance
of payment.
|
International transactions
|
Balance of trade gives a partial picture
of the international transactions of a country.
|
Balance of payment gives a full picture
of the international transactions of a country.
|
Component
|
It is a component of current account of
balance of payment.
|
It has two components – capital account
and current account.
|
Result
|
It can be favourable, unfavourable and
balanced.
|
Both the receipts and payments sides
tallies.
|
Q.8. Explain how the equilibrium price of a
foreign currency is determined in foreign exchange market?
Ans:
Foreign exchange market is the market where national currencies are traded for
one another. Foreign exchange rate refers to the rate at which the currency of
one country is exchanged, with the currency of another country. Like other
prices, the rate of exchange is also determined in accordance with the general
theory of value that is by the interaction of the forces of demand and supply.
If the demand for foreign exchangeable currency increases, then the new
exchange rate indicates devaluation of domestic currency. As a result of
increasing price of foreign currency, more domestic currency is spent while
purchasing foreign goods. Consequently, import falls, resulting to fall of
demand for money. Again, if the supply of foreign exchange increases then
elasticity of demand for produced goods within the country must be greater than
one. Under this situation, quantity of foreign currencies increases through
export. Hence, demand and supply determined the price of equilibrium foreign
exchange rate.
Q.9. Explain how exchange rate is
determined in a system of flexible exchange rate.
Ans.
Flexible exchange rate is that rate which is determined by the forces of demand
and supply of foreign exchange. The central banks do not intervene for the
foreign exchange market.
Q.10. Explain briefly various determinants
of exchange rate under flexible exchange rate system.
Ans:
Under flexible exchange rate the factors that influence the exchange rate
between the currencies of two countries. Besides from export and import the
following factors play a vital role in the determination of flexible exchange
rate.
1) Speculation:
Money is considered as an asset in every country. If the demand for foreign
exchange increases, supply schedule remains same, the exchange rate will rise.
If the speculators expect to fall in the value of currency in the near future,
they will sell the currency and start buying the other currency they expect to
appreciate in value.
2) Interest
Rate: In the short run, another factor determining the exchange rate movement
is the interest rate differential. If the bank rate rises relative to other
countries, more funds will flow into the country from abroad to earn high
interest rate. It will lead to raise the demand for the domestic currency and
the exchange rate will move in favour of the country.
3) Income:
When the income of consumer increases, consumer can spend more things than
before. So, spending on imported goods will also increase which led rightward
shifts of demand curve for foreign exchange. As a result, the domestic currency
depreciates.
Q.11. What is Disequilibrium in Balance of
Payments? Explain various causes behind deficit in BOP. 2015,2017
Ans: Disequilibrium in Balance of Payments:
Balance of payments always balances in the accounting sense. The overall
account of the balance of payments necessarily balance or must always be in
equilibrium. It is because of the reason that balance of payment is prepared in
terms of credits and debits based on the system of double entry book-keeping.
Under the system, the two sides are kept equal.
Causes behind Deficit in BOP: Deficit in BOP
is caused by a variety of factors which are given below
a) Huge
Development Expenditure: When a backward country starts various development
schemes often needs the imports of machines, raw materials, etc. This raises
the country’s import bill and consequently its BOP becomes adverse.
b) 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 cannot be met out of domestic production.
c) Inflation:
Inflation may also cause deficit in the balance of payments; Exports decrease
as a result of inflation and at the same time the demand for imports increases.
d) Change
in Foreign Exchange Rates: When the external value of the domestic currency
goes up, imports become cheaper and exports dearer.
Q.12. What are two components of BOP?
Explain and distinguish between them.
Ans: Current Account: Current account
is that account of BOP which records imports and exports of goods and services
and unilateral transfers. It thus, records the following three items:
a) Visible
items of trade
b) Invisible
items and
c) Unilateral
transfers
Current account deals with currently produced goods and services. Current
account transactions are called account of actual transaction, because all the
items included in it are actually transacted.
Items of Current Account
1) Exports
and Import of Visible Items or Goods.
2) Invisible
Items (or Non-Material Goods or Services).
3) Unilateral Transfers.
Capital Account: Capital
account is that account of BOP which records all such transactions between the
residents of a country and rest of the world which cause a change in the asset
or liability of the country. It concerns with capital transactions – all kinds
of short term and long term international capital transfers, gold and
sale/purchase of assets. It also deals with the payments of debts and claims.
Main items of capital account are listed below:
a) Direct
Investment.
b) Portfolio
Investment.
c) Loans.
d) Banking
Capital Transactions.
Difference between Current Account
and Capital Account of BOP: The main points of difference between current
account and capital accounts are as follows:
1) Current
account records economic transactions relating to exchange of goods and
services and unilateral transfers while capital account records capital
transaction, e.g. borrowing and lending, sale and purchase of assets, change in
the stock of gold and foreign exchange.
2) Current
account transactions are of flow nature, while capital transactions are of
stock nature.
3) Current
account transactions bring about a change in the current level of a country’s
income, whereas capital transactions bring about a change in the capital stock
of a country.
Q.13. What are the main sources of demand
for foreign exchange?
Ans: Following
are the main sources of demand for foreign exchange:
1) To
purchase goods and services from other countries by the domestic residents.
2) To
send gifts and grants to foreign countries.
3) To
speculate on the value of foreign currencies.
4) To
make payments of international loans.
Q.14. What are the main sources of supply
of foreign exchange?
Ans: Following
are the sources of supply of foreign exchange:
a) Foreigner’s
purchasing domestic country’s goods and services through exports.
b) Direct
foreign investment in the domestic country.
c) Flow
of foreign exchange due to speculative purchases by the non-residents in the
domestic country.
d) Remittances
by the non-residents living abroad.