Friday, December 15, 2017

AHSEC CLass 12 Economics Part B Notes: Unit – 6: Balance of Payments


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.
 
 In the above diagram, DD, D1D1 and D2D2 represents demand for foreign exchange and SS curve represents the supply of foreign currencies. There is an inverse relation between foreign exchange rate and demand for foreign exchange. Graphically, the demand curve of foreign exchange is downward sloping indicating that there is an inverse relationship between foreign exchange rate and demand for foreign exchange. But there is a direct relation between foreign exchange rate and supply of foreign exchange. Higher the exchange rate, higher the supply of foreign exchange and lower the exchange rate, lower the supply of foreign exchange.   

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. 

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