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TEST-8 EXPLANATION PDF

October 6th, 2019

Lesson 6
India’s External Sector
India’s External Sector ............................................. 2 Exchange Rate in the Long Run ......................... 14
Meaning of An Open Economy ............................ 2 Fixed Exchange Rate .......................................... 14
Output Market Linkage..................................... 2 Advantages and Disadvantages of Fixed Exchange
Rate Systems...................................................... 16
Financial Market Linkage .................................. 2
Advantages and Disadvantages of Flexible
Labour Market Linkage ..................................... 2 Exchange Rate.................................................... 16
Meaning of Closed Economy ............................... 2 Managed Floating (Managed Flexible Exchange
Pros and Cons of an Open Economy .................... 3 Rate)................................................................... 17
Advantages of an Open Economy..................... 3 Steps that can be taken to control too much
Deprecation ....................................................... 18
Disadvantages of an Open Economy ................ 3
Nominal and Real Exchange Rate ................... 19
Balance of Payment ............................................. 3
Nominal Exchange Rate ..................................... 19
Meaning ............................................................ 3
Real Exchange Rate ............................................ 19
Current Account ............................................... 4
Exchange Rate Management in India................. 19
Trade in Goods ..................................................... 4
The Indian Experience ..................................... 19
Trade in Services .................................................. 4
Convertibility of Rupee ................................... 20
Transfer Payments ............................................... 5
Concept of Convertibility ................................... 20
Balance on Current Account ................................ 6
Concept of Current Account Convertibility ....... 20
Capital Account ................................................. 7
Concept of Capital Account Convertibility......... 21
Investments.......................................................... 7
Is Indian National Rupee Convertible? .............. 21
External Borrowings ............................................. 8
Advantages of a Fully Convertible Currency ...... 22
External Assistance .............................................. 8
Disadvantages of A Fully Convertible Currency . 23
Balance on Capital Account ................................. 8
India’s FOREX Reserves ................................... 23
Representative Balance of Payments for India 8
What are Forex Reserves? ................................. 23
Balance of Payments Surplus and Deficit ......... 9
RBI Act 1934 and Forex Reserves ...................... 23
BoP Surplus .......................................................... 9
Objectives of Holding Forex Reserves ............... 23
BoP Deficit ............................................................ 9
Components of India's Foreign Exchange
BoP – Achieving a Balance ................................... 9 Reserves ............................................................. 23
Official Reserve Sale ............................................. 9 MCQs for Practice................................................... 25
Autonomous and Accommodating Transactions
MCQs with Answer and Explanation ...................... 26
............................................................................10
Errors and Omissions .........................................10
Foreign Exchange Market .................................. 11
Foreign Exchange Rate ................................... 11
Demand for Foreign Exchange ...........................11
Supply of Foreign Exchange ...............................11
Determination of the Exchange Rate ............. 12
Flexible Exchange Rate.......................................12
Speculation.........................................................13
Interest Rates and the Exchange Rate ...............13
Income and Exchange Rate ................................13
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INDIA’S EXTERNAL SECTOR
MEANING OF AN OPEN ECONOMY
An open economy is one which interacts with other
countries through various channels. So far, we had
not considered this aspect and just limited to a
closed economy in which there are no linkages with
the rest of the world in order to simplify our analysis
and explain the basic macroeconomic mechanisms.
In reality, most modern economies are open. There
are three ways in which these linkages are
established.
OUTPUT MARKET LINKAGE
An economy can trade in goods and services with
other countries. This widens choice in the sense that
consumers and producers can choose between
domestic and foreign goods.
FINANCIAL MARKET LINKAGE
The movement of capital is essentially investment.
While the flow of physical capital can and does occur,
the flow of financial capital is quite common in open
economies. Financial capital is the funds used to
purchase physical capital, and is much easier to
"transport" than physical capital. The flow of
financial funds into and out of open economies is
termed foreign direct investment. The flow of funds
into an open economy means foreign citizens gain
ownership (and often management control) over
physical capital, something that concerns domestic
citizens.
LABOUR MARKET LINKAGE
The movement of labour, generally termed
migration, flows into and out of an open economy.
The flow of labour into an economy is termed
immigration and the flow out is termed emigration.
The movement of labour is largely in response to
wage differentials between economies. That is,
workers are attracted to higher wages.
KEY DEFINITION
Open Economy: An economy that engages in
international trade, especially one that exports
goods and services to, and imports goods and
services from, other economies that make up its
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foreign sector. It is "open" in the sense that goods
and services flow into and out of the country. The
alternative to an open economy is a closed
economy, one that does not engage in
international trade.
MEANING OF CLOSED ECONOMY
The alternative to an open economy is a closed
economy. A closed economy is a nation that does
not engage in international trade. The country has
neither exports nor imports and no other economic
interaction with the foreign sector. Its borders are
effectively "closed" to the rest of the world.
While examples of closed economies populate the
historical landscape, virtually all economies in the
modern world are open and engage in assorted
forms of international interaction, particularly
international trade. The question is not so much one
of open versus closed, but the degree of openness.
Some open economies engage in only limited
interaction with their foreign sector and are largely
self-sufficient. Others engage in a great deal more
international interaction.
Large economies, like that in the United States, tend
to more self-sufficient that smaller economies, such
as Denmark, and thus engage in relatively less
international trade. For this reason smaller
economies tend to be relatively more open than
larger economies.
KEY DEFINITION
International Trade: The economic interaction
among different nations involving the exchange of
goods and services, that is, exports and imports.
The guiding principle of international trade is
comparative advantage, which indicates that
every country, no matter their level of
development, can find something that it can
produce cheaper than another country.
International finance, the study of payments
between nations, is a related area of international
economics. A summary of international trade
undertaken by a particular nation is given with the
balance of trade.
Degree of Openness: Economic openness, in
political economy, the degree to which
 nondomestic transactions (imports and exports)
take place and affect the size and growth of a
national economy. The degree of openness is
measured by the actual size of registered imports
and exports within a national economy, also
known as the Impex rate. This measure is
presently used by most political economists in
empirically analyzing the impact and
consequences of trading on the social and
economic situation of a country.
Where X is total exports and M is total imports in
one accounting period.
PROS AND CONS OF AN OPEN
ECONOMY
ADVANTAGES OF AN OPEN ECONOMY
▪ Collaboration drives growth. In an open
economy, people can exchange goods and
services, start or expand their business across
borders and enjoy lower costs.
▪ Customers have access to a wide range of
products that may not be otherwise available.
▪ This type of economy encourages competition
among domestic producers, which translates
into higher quality products and lower prices.
▪ Another advantage of an open economy is the
ability to sell exports at higher prices and get
cheaper imports.
▪ Entrepreneurship is highly encouraged as well.
Those who plan to start a business can freely
exchange information and resources with
foreign companies. This allows them to keep the
costs low and access the latest technologies so
they can offer innovative products at
competitive rates.
▪ Furthermore, access to technology and know-
how boosts productivity and innovation in the
workplace.
DISADVANTAGES OF AN OPEN
ECONOMY
▪ Despite their apparent advantages, open
economies are far from perfect. First of all,
they're vulnerable to external threats. Price
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fluctuations, market crashes and high
unemployment rates in one country can spread
to other economies.
▪ In an open economy, many businesses may try to
reduce their costs and maximize profits by
exploiting employees or importing poor quality
products and raw materials.
▪ Additionally, large organizations can dominate
certain markets, creating monopolies and
setting unfair prices. The increasing number of
foreign companies can kill local businesses.
BALANCE OF PAYMENT
MEANING
The balance of payments (BoP) record the
transactions in goods, services and assets between
residents of a country with the rest of the world for
a specified time period typically a year. There are
two main accounts in the BoP — the current
account and the capital account.
There is a new classification in which the balance of
payments have been divided into three accounts —
the current account, the financial account and the
capital account. This is as per the new accounting
standards specified by the International Monetary
Fund (IMF) in the sixth edition of the Balance of
Payments and International Investment Position
Manual (BPM6). India has also made the change but
the Reserve Bank of India continues to publish data
accounting to the old classification. The most
important change is that almost all the transactions
arising on account of trade in financial assets such as
bonds and equity shares are now placed in the
financial account. However, RBI continues to publish
the balance of payments accounts as per the old
system also, therefore the details of the new system
are not being given here. The details are given in the
Balance of Payments Manual for India published by
the Reserve Bank of India in September 2010.
KEY DEFINITION
Balance of payments: The difference between the
funds received by a country and those paid by a
country for all international transactions. The
international transactions include the exchange of
merchandise (exports and imports), which is
commonly summarized as the balance of trade,
 plus the exchange of services, summarized as the
balance of services, as well as any gifts or transfer
payments that do not involve the exchange of
goods and services. The balance of payments, in
effect, indicates the difference between currency
coming into a country and that flowing out of the
country. The balance of payments is divided into
two accounts -- current account (which includes
payments for imports, exports, services, and
transfers) and capital account (which includes
payments for physical and financial assets).
CURRENT ACCOUNT
The current account is a record of all trade between
one nation and other nations. It includes payments
for imports and exports of both goods and services.
It also includes monetary gifts or transfer payments
to and from other nations. The current account of
the balance of payments is record of the flow of
payments between one country and other
countries that result from: (1) the exchange of
goods (exports and imports), which is the balance of
trade, (2) the exchange of services, summarized as
the balance of invisibles, and (3) any gifts or transfer
payments that do not involve the exchange of goods
and services, which is unilateral transfers.
Current
Account
Trade in
Trade in Goods
Services
Exports of Imports of Net Factor Net Non-factor
Goods Goods Income
TRADE IN GOODS
Trade in goods includes exports and imports of
goods
EXPORTS OF GOODS
Exports of goods is sale of domestically produced
goods to a foreign country. India, for example, sells
a lot of the stuff produced within our boundaries to
other countries. In general, domestic producers (and
their workers) are elated with the prospect of selling
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their goods to foreign countries--leading to more
buyers, a higher price, and more profit.
Major exports from India include: Precious stones
and metals, Refined petroleum, Automobiles,
Machinery and mechanical appliances, Organic
chemicals, Pharmaceutical products, Iron and steel,
Textiles and Electrical machinery.
IMPORTS OF GOODS
Imports of goods refer to goods produced by the
foreign sector and purchased by the domestic
economy. In other words, imports are goods
purchased from other countries. India, for example,
buys a lot of the stuff produced within the
boundaries of other countries.
Major imports into India include: Petroleum Oil and
Lubricants, Capital Goods (Machinery, Base metal,
Transport equipment), Gems and Jewellery,
Chemical and Related Products (Organic chemicals,
Fertilizers), Electronic Goods, Agriculture and Allied
Products and Ores and Minerals (Coal, Coke, etc.)
Buying foreign goods is expenditure from our
country and it becomes the income of that foreign
country. Hence, the purchase of foreign goods or
imports decreases the domestic demand for goods
and services produced in our country.
Imports, together with exports, are the essence of
foreign trade--goods and services that are traded
Transfer
among the citizens of different nations. Imports and
Payments
exports are frequently combined into a single term,
net exports (exports minus imports).
Gifts,
Remittances
Income
and Grants TRADE IN SERVICES
Trade in services includes factor income and non-
factor income transactions.
NET FACTOR INCOME FROM ABROAD
While most production within a nation's political
boundaries is undertaken by resources owned by
citizens of that nation, there are exceptions. Some
citizens own resources that do their production in
the foreign sector. And some resources owned by
foreign citizens do their production within the
political boundaries of the domestic economy. Net
factor income captures these exceptions.
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Suppose, for example, that a foreign citizen is
employed in the domestic economy. For example,
suppose that Yuri Boyka, a citizen of Russia, has
found employment in India. Boyka’s productive
efforts is included in gross DOMESTIC product, but
not gross NATIONAL product. Boyka’s income falls
under the heading of factor payments made to
foreign citizens for domestic production.
Alternatively, suppose a domestic citizen is
employed in the foreign sector. For example,
suppose that Vijendar Singh, a citizen of India, finds
employment in Russia. Singh's productive efforts
are included in gross NATIONAL product, but not
gross DOMESTIC product. Singh's income falls under
the heading of factor payments received from the
foreign sector by domestic citizens.
If Boyka earns Rs 15 lakhs in a given year for his
productive efforts in India, while Singh earns Rs 20
lakhs for this work in Russia, then net factor income
from abroad is Rs 5 lakhs (Rs 20 lakhs – Rs 15 lakhs).
As such, gross DOMESTIC product is Rs 5 lakhs LESS
than gross NATIONAL product.
Net factor income from abroad (NFIA) captures the
net flow of income payments between the
domestic economy and the foreign sector. It is the
difference foreign payments to domestic citizens
and domestic income payments to foreign citizens.
NFIA is usually quite small. However, the two
components of net foreign factor income: (1)
foreign payments to domestic citizens and (2)
domestic payments to foreign citizens are more
substantial. Net foreign factor income is small
because the two larger components almost cancel
out.
KEY DEFINITION
Factor Services: Comprises services of labour and
capital, thus covering income from direct
investment abroad, interest, dividends, and
property and labour income.
Net Factor Income from Abroad: The difference
between factor payments received from the
foreign sector by domestic citizens and factor
payments made to foreign citizens for domestic
production. Net factor income from abroad (NFIA)
is the key difference between gross DOMESTIC
product and gross NATIONAL product
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NET NON-FACTOR INCOME
Non-factor services comprise shipment, passenger
and other transport services, and travel, as well as
current account transactions not separately
reported (e.g., not classified as merchandise,
nonfactor services, or transfers).
Software exports are classified within invisibles
under the sub-head `miscellaneous non-factor
services'. Non-factor services refer to all invisible
receipts or payments not attributable to any of the
conventional `factors of production', i.e. labour
(remittances from overseas migrants) and capital
(income from investments, interest payments,
dividend repatriation). Thus, non-factor services
include forex earnings and expenses on account of
tourism, shipping/freight and various
`miscellaneous' sub-heads, under which export of
software features.
KEY DEFINITION
Invisibles: Payments and receipts resulting from
international trade in 'invisible' services instead of
'visible' goods. Invisibles include banking,
franchising, insurance, interest (on foreign
investments), licensing, profit repatriation (from
foreign subsidiaries), salary remittances (from
nationals employed abroad), shipping, and
tourism.
QUESTION 1
Q. In terms of economy, the visit by foreign
nationals to witness the XIX commonwealth
games in India amounted to [2011 - I]
(a) Export
(b) Import
(c) Production
(d) Consumption
Answer: A
TRANSFER PAYMENTS
Transfers represent one-sided transactions, i.e.,
transactions that do not have any quid pro quo, such
as grants, gifts, and migrants’ transfers by way of
remittances for family maintenance, repatriation of
savings and transfer of financial and real resources
linked to change in resident status of migrants.
Official transfer receipts include grants, donations
and other assistance received by the Government
from bilateral and multilateral institutions. Similar
transfers by Indian Government to other countries
are recorded under official transfer payments.
BALANCE ON CURRENT ACCOUNT
Current Account is in balance when receipts on
current account are equal to the payments on the
current account. A surplus current account means
that the nation is a lender to other countries and a
deficit current account means that the nation is a
borrower from other countries.
Current Balanced Current
Account Current Account
Surplus Account Deficit
Receipts > Receipts = Receipts <
Payments Payments Payments
Balance on Current Account has three components:
▪ Balance of Trade or Trade Balance
▪ Balance on Invisibles
▪ Balance on Transfers (included in Balance on
Invisibles)
BALANCE OF TRADE
Balance of Trade (BOT) is the difference between
the value of exports and value of imports of goods
of a country in a given period of time. Export of
goods is entered as a credit item in BOT, whereas
import of goods is entered as a debit item in BOT. It
is also known as Trade Balance.
BOT is said to be in balance when exports of goods
are equal to the imports of goods.
Surplus BOT or Trade surplus will arise if country
exports more goods than what it imports.
Whereas, Deficit BOT or Trade deficit will arise if a
country imports more goods than what it exports.
BALANCE ON INVISIBLES
Net Invisibles is the difference between the value of
exports and value of imports of invisibles of a
country in a given period of time.
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Invisibles include services, transfers and flows of
income that take place between different countries.
Services trade includes both factor and non-factor
income.
Factor income includes net international earnings
on factors of production (like labour, land and
capital).
Non-factor income is net sale of service products
like shipping, banking, tourism, software services,
etc.
KEY DEFINITION
Balance of Trade: The difference between funds
received by a country when exporting
merchandise and the funds paid for importing
merchandise. The balance of trade is a major part
of the current accounts portion of the balance of
payments. A balance of trade surplus results if
exports exceed imports, commonly termed a
favorable balance of trade, and a balance of trade
deficit exists if imports exceed exports,
analogously termed an unfavorable balance of
trade.
Balance of Services: The difference between
funds received by a country when exporting
services and the funds paid for importing services.
The balance of services is one part of the current
accounts portion of the balance of payments, the
other is major part is the balance of trade. The
balance of services is very much like the
merchandise balance of trade, excepct intangible
services are being exported and imported rather
than tangible goods. Like the balance of trade, the
balance of services can be out of balance. A
balance of services surplus results if service
exports exceed imports, also termed a favorable
balance of services, and a balance of services
deficit exists if service imports exceed exports,
analogously termed an unfavorable balance of
services.
Balance of Transfer: This is the difference
between gifts or transfers received from other
nations and transfers sent to other nations. In
includes gifts or transfers between individuals,
and perhaps more important, it includes transfers
between governments.
 QUESTION 2
Q. Consider the following actions which the
government can take: [2011 - I]
1. Devaluing the domestic currency.
2. Reduction in the export subsidy.
3. Adopting suitable policies which attract greater
FDI and more funds from FIIs.
Which of the above action/actions can help in
reducing the current account deficit?
(a) 1 and 2
(b) 2 and 3
(c) 3 only
(d) 1 and 3
Answer: D
QUESTION 3
Q. With reference to Balance of Payments,
which of the following constitutes/constitute the
Current Account? [2014 - I]
1. Balance of trade
2. Foreign assets
3. Balance of invisibles
4. Special Drawing Rights
Select the correct answer using the code given
below:
(a) 1 only
(b) 2 and 3
(c) 1 and 3
(d) 1, 2 and 4
Answer: C
CAPITAL ACCOUNT
Capital Account records all international
transactions of assets. An asset is any one of the
forms in which wealth can be held, for example:
money, stocks, bonds, Government debt, etc.
Purchase of assets is a debit item on the capital
account. If an Indian buys a UK Car Company, it
enters capital account transactions as a debit item
(as foreign exchange is flowing out of India). On the
other hand, sale of assets like sale of share of an
Indian company to a Chinese customer is a credit
item on the capital account. Following figures
classifies the items which are a part of capital
account transactions. These items are Foreign
Direct Investments (FDIs), Foreign Institutional
Investments (FIIs), external borrowings and
assistance.
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Capital
Account
External External
Investments
Borrowings Assitance
Direct Portfolio ECB, Short-
Aid, Loans
Investment Investment Term Debt
FDI, Equity FII, Offshore
Capital Funds
INVESTMENTS
Foreign investment involves capital flows from one
country to another, granting extensive ownership
stakes in domestic companies and assets. Foreign
investment denotes that foreigners have an active
role in management as a part of their investment.
DIRECT INVESTMENTS
Direct Investment is the acquisition of controlling
interest in foreign firms and businesses from one
country in another country. Abbreviated FDI, foreign
direct investment can also take the form of
constructing factories, structures and equipment
(or any form of physical capital) in foreign soil.
Domestic Direct Investment in Foreign Sector: This
is the net flow of payments used by those in the
domestic economy to purchase physical assets in
other nations. (Example: Indian buys a UK car
company)
Foreign Direct Investment in Domestic Sector: This
is the net flow of payments used by those in the
foreign sector to purchase physical assets in the
domestic economy. (Example: Chinese buys an
Indian car company)
PORTFOLIO INVESTMENTS
Portfolio Investment is the acquisition of financial
assets (which includes stock, bonds, deposits, and
currencies) from one country in another country. In
contrast to foreign direct investment, which is the
acquisition of controlling interest in foreign firms
and businesses, portfolio investment is foreign
investment into the stock markets. Most
economists consider foreign direct investment more
useful than portfolio investment since the latter is
generally regarded as temporal and can leave the
foreign country at the first sign of trouble.
Domestic Portfolio Investment in Foreign Sector:
This is the net flow of payments used by those in the
domestic economy to purchase financial assets in
other nations.
Foreign Portfolio Investment in Domestic Sector:
This is the net flow of payments used by those in the
foreign sector to purchase financial assets in the
domestic economy.
QUESTION 4
Q. Global capital flows to developing countries
increased significantly during the nineties. In
view of the East Asian financial crisis and Latin
American experience, which type of inflow is
good for the host country? [2002]
(a) Commercial loans
(b) Foreign Direct Investment
(c) Foreign Portfolio Investment
(d) External Commercial borrowings
Answer: B
QUESTION 5
Q. Both Foreign Direct Investment (FDI) and
Foreign Institutional Investor (FII) are related to
investment in a country. Which one of the
following statements best represents an
important difference between the two? [2011 - I]
(a) FII helps bring better management skills and
technology, while FDI only brings in capital.
(b) FII helps in increasing capital availability in
general, while FDI only targets specific sectors.
(c) FDI flows only into the secondary market while
FII targets primary market
(d) FII is considered to be more stable than FDI.
Answer: B
QUESTION 6
Q. Which of the following would include Foreign
Direct Investment in India? [2012 - I]
1. Subsidiaries of foreign companies in India
2. Majority foreign equity holding in Indian
companies
3. Companies exclusively financed by foreign
companies
4. Portfolio investment
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Select the correct answer using the codes given
below:
(a) 1, 2, 3 and 4
(b) 2 and 4 only
(c) 1 and 3 only
(d) 1, 2 and 3 only
Answer: D
EXTERNAL BORROWINGS
External debt is the portion of a country's debt that
was borrowed from foreign lenders, including
commercial banks, governments, or international
financial institutions. These loans, including
interest, must usually be paid in the currency in
which the loan was made. To earn the needed
currency, the borrowing country may sell and export
goods to the lender's country.
External Commercial borrowings cover all
medium/long term loans. It denotes drawls/
repayment of loans including buyers’ credit,
suppliers’ credit, floating rate notes (FRNs),
commercial paper (CP), bonds, foreign currency
convertible bonds (FCCBs) issued abroad by the
Indian corporates etc.
EXTERNAL ASSISTANCE
External assistance by India denotes aid extended by
India to other foreign Governments under various
agreements and repayment of such loans. External
Assistance to India denotes multilateral and
bilateral loans received under the agreements
between Government of India and other
Governments/International institutions and
repayments of such loans by India.
BALANCE ON CAPITAL ACCOUNT
Capital account is in balance when capital inflows
(like receipt of loans from abroad, sale of assets or
shares in foreign companies) are equal to capital
outflows (like repayment of loans, purchase of
assets or shares in foreign countries). Surplus in
capital account arises when capital inflows are
greater than capital outflows, whereas deficit in
capital account arises when capital inflows are
lesser than capital outflows.
REPRESENTATIVE BALANCE OF
PAYMENTS FOR INDIA
 No. Item Million USD
1. Exports (of goods only) 150 Fixing the currency exchange rate below the
2. Imports (of goods only) 240 flexible exchange rate equilibrium level not only
3. Trade Balance [2 – 1] –90 generates a balance of trade surplus (as the
4. (Net) Invisibles [4a + 4b + 4c] 52 relatively low exchange rate encourages exports and
a. Non-factor Services 30 discourages imports), but it can also temporarily
b. Income –10 generate a balance of payments surplus (as more
c. Transfers 32 payments come in for exports than go out for
5. Current Account Balance [ 3+ 4] –38 imports).
6. Capital Account Balance [6a +
41.15
6b + 6c + 6d + 6e + 6f]
a. External Assistance (net) 0.15 BOP DEFICIT
b. External Commercial
2
Borrowings (net) Alternatively, a balance of payments deficit would
c. Short-term Debt 10 occur if the balance is less than zero. This means that
d. Banking Capital (net) of which 15 the country has a net outflow of payments. More
Non-resident Deposits (net) 9 payments are going out of the country for imports,
e. Foreign Investments (net) of transfers, or investments than are coming in.
which 19
[6eA + 6eB] Fixing the currency exchange rate above the flexible
A. FDI (net) 13 exchange rate equilibrium level not only generates
B. Portfolio (net) 6 a balance of trade deficit (as the relatively high
f. Other Flows (net) –5 exchange rate discourages exports and encourages
7. Errors and Omissions 3.15 imports), but it can also temporarily generate a
8. Overall Balance [5 + 6 + 7] 0 balance of payments deficit (as fewer payments
9. Reserves Change 0 come in for exports than go out for imports).

QUESTION 7 BOP – ACHIEVING A BALANCE

Q. Which of the following constitute Capital
Account? [2013 - I] The essence of international payments is that just
1. Foreign Loans like an individual who spends more than her income
2. Foreign Direct Investment must finance the difference by selling assets or by
3. Private Remittances borrowing, a country that has a deficit in its current
4. Portfolio Investment account (spending more than it receives from sales
Select the correct answer using the codes given to the rest of the world) must finance it by selling
below: assets or by borrowing abroad. Thus, any current
(a) 1, 2 and 3 account deficit must be financed by a capital
(b) 1, 2 and 4 account surplus, that is, a net capital inflow.
(c) 2, 3 and 4
(d) 1, 3 and 4 Current account + Capital account = 0
Answer: B
In this case, in which a country is said to be in balance
of payments equilibrium, the current account deficit
BALANCE OF PAYMENTS SURPLUS is financed entirely by international lending without
AND DEFICIT any reserve movements.
BOP SURPLUS OFFICIAL RESERVE SALE

A balance of payments surplus would occur if the Alternatively, the country could use its reserves of
balance is greater than zero. This means that the foreign exchange in order to balance any deficit in
country has a net inflow of payments. More its balance of payments. The reserve bank sells
payments are coming in to the country for exports, foreign exchange when there is a deficit. This is
transfers, or investments than are going out.
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called official reserve sale. The decrease (increase)
in official reserves is called the overall balance of External sector: It refers to the economic
payments deficit (surplus). transaction of the domestic country with the rest
of the world.
The basic premise is that the monetary authorities
are the ultimate financiers of any deficit in the Exports: Sale of goods and services by the
balance of payments (or the recipients of any domestic country to the rest of the world.
surplus). We note that official reserve transactions
are more relevant under a regime of fixed exchange Imports: Sale of goods and services to the
rates than when exchange rates are floating. domestic country by the rest of the world.
AUTONOMOUS AND ACCOMMODATING Foreign Direct Investment: A foreign direct
TRANSACTIONS
investment (FDI) is an investment made by a firm
or individual in one country into business interests
International economic transactions are called
located in another country.
autonomous when transactions are made due to
some reason other than to bridge the gap in the
Foreign Portfolio Investment: Foreign portfolio
balance of payments, that is, when they are
investment (FPI) consists of securities and other
independent of the state of BoP. One reason could
financial assets held by investors in another
be to earn profit. These items are called ‘above the
country. It does not provide the investor with
line’ items in the BoP. The balance of payments is
direct ownership of a company's assets and is
said to be in surplus (deficit) if autonomous receipts
relatively liquid depending on the volatility of the
are greater (less) than autonomous payments.
market.
Accommodating transactions (termed ‘below the
External Debt: External debt is the portion of a
line’ items), on the other hand, are determined by
country's debt that was borrowed from foreign
the gap in the balance of payments, that is, whether
lenders, including commercial banks,
there is a deficit or surplus in the balance of
governments, or international financial
payments. In other words, they are determined by
institutions.
the net consequences of the autonomous
transactions. Since the official reserve transactions
Balance of payments: A set of accounts that
are made to bridge the gap in the BoP, they are seen
summarise a country’s transactions with the rest
as the accommodating item in the BoP (all others
of the world.
being autonomous).

ERRORS AND OMISSIONS Foreign exchange reserves: Foreign assets held by

the central bank of the country.
It is difficult to record all international transactions
accurately. Thus, we have a third element of BoP Official Reserve Transactions: Official reserve
(apart from the current and capital accounts) called transactions are the transactions made by the
errors and omissions which reflects this. Central Bank which cause changes in its official
reserves of foreign exchange. It takes effect in the
foreign reserve of the country. This transaction
BoP Deficit Balanced BoP BoP Surplus happens only when an economy withdraws from
its stock of foreign exchange reserves to finance
the deficit in its overall Balance of Payments.
Overall Overall Overall
Balance < 0 Balance = 0 Balance > 0
QUESTION 8
Reserve Reserve Reserve Q. Consider the following statements: [2006]
Change > 0 Change = 0 Change < 0 Assertion (A): Balance of Payments represents a
better Picture of a country economic transactions
with the rest of the world than the Balance of
KEY DEFINITION Trade Balance of Payments takes into account
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 Reason (R): the exchange of both visible and
invisible items whereas balance of Trade does not.
Select the correct answer using the code given
below:
(a) Both ‘A’ and ‘R’, are individually true and ‘R’ is
the correct explanation of ‘A’.
(b) Both ‘A’ and ‘R’ are individually true but ‘R’ is
not the, correct explanation of ‘A’.
(c) ‘A’ is true but ‘R’ is false.
(d) ‘A’ is false but ‘R’ is true.
Answer: A
QUESTION 9
Q. In the context of India, which of the following
factors is/are contributor/contributors to
reducing the risk of a currency crisis? [2019]
1. The foreign currency earnings of India’s IT
sector.
2. Increasing the government expenditure.
3. Remittances from Indians abroad.
Select the correct answer using the code given
below:
(a) 1 only
(b) 1 and 3 only
(c) 2 only
(d) 1, 2 and 3
Answer: B
FOREIGN EXCHANGE MARKET
So far, we have considered the accounting of
international transactions on the whole, we will now
take up a single transaction.
Let us assume that a single Indian resident wants to
visit London on a vacation (an import of tourist
services). She will have to pay in pounds for her stay
there. She will need to know where to obtain the
pounds and at what price. This price is known as the
exchange rate. The market in which national
currencies are traded for one another is known as
the foreign exchange market. The major
participants in the foreign exchange market are
commercial banks, foreign exchange brokers and
other authorised dealers and monetary authorities.
It is important to note that although participants
themselves may have their own trading centres, the
market itself is world-wide. There is a close and
continuous contact between the trading centres and
the participants deal in more than one market.
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KEY DEFINITION
Foreign exchange: Foreign currency, all currencies
other than the domestic currency of a given
country.
FOREIGN EXCHANGE RATE
Foreign Exchange Rate (also called Forex Rate) is the
price of one currency in terms of another. It links
the currencies of different countries and enables
comparison of international costs and prices. For
example, if we have to pay Rs 70 for $1 then the
exchange rate is Rs 70 per dollar. To make it simple,
let us consider that India and USA are the only
countries in the world and so there is only one
exchange rate that needs to be determined.
KEY DEFINITION
Exchange Rate: An exchange rate is the value of
one nation's currency versus the currency of
another nation or economic zone. For example,
how many Indian Rupees does it take to buy one
dollar? As of Jan. 22, 2020, the exchange rate is
71.12, meaning it takes Rs 71.12 to buy $1.
DEMAND FOR FOREIGN EXCHANGE
People demand foreign exchange because: they
want to purchase goods and services from other
countries; they want to send gifts abroad; and, they
want to purchase financial assets of a certain
country. A rise in price of foreign exchange will
increase the cost (in terms of rupees) of purchasing
a foreign good. This reduces demand for imports
and hence demand for foreign exchange also
decreases, other things remaining constant.
SUPPLY OF FOREIGN EXCHANGE
Foreign currency flows into the home country due to
the following reasons: exports by a country lead to
the purchase of its domestic goods and services by
the foreigners; foreigners send gifts or make
transfers; and, the assets of a home country are
bought by the foreigners. A rise in price of foreign
exchange will reduce the foreigner’s cost (in terms
of USD) while purchasing products from India, other
things remaining constant. This increases India’s
exports and hence supply for foreign exchange may increase in demand for foreign goods and services
increase. result in a change in the exchange rate.

DETERMINATION OF THE EXCHANGE

RATE

Different countries have different methods of

determining their currency’s exchange rate. It can be
determined through Flexible Exchange Rate, Fixed
Exchange Rate or Managed Floating Exchange Rate.

FLEXIBLE EXCHANGE RATE

A flexible exchange rate is a "hands off," non-

intervening policy that allows the foreign exchange
market to adjust to equilibrium through the balance
of demand and supply with no explicit government
actions. The presumption is that the resulting The initial exchange rate e* = 70, which means that
exchange rate generates a better outcome for we need to exchange Rs 50 for one dollar. At the
international trade, the balance of trade, and the new equilibrium, the exchange rate becomes e1 =
balance of payments than what could be achieved 75, which means that we need to pay more rupees
through government intervention. for a dollar now (i.e., Rs 75). It indicates that the
value of rupees in terms of dollars has fallen and
As depicted in the following figure, the exchange value of dollar in terms of rupees has risen.
rate is determined where the demand curve
Demand Curve Supply Curve
intersects with the supply curve, i.e., at point e on
the Y – axis. Point q on the x – axis determines the Meaning Implication Meaning Implication
quantity of US Dollars that have been demanded and
Supply Demand
supplied on e exchange rate. In a completely flexible Demand remaining Supply remaining
Shifts
system, the Central banks do not intervene in the Rightwards
has constant, has constant,
increased price will increased prices will
foreign exchange market.
increase decrease

Supply Demand
Demand remaining Supply remaining
Shifts
has constant, has constant,
Leftwards
decreased price will decreased prices will
decrease increase

DEPRECIATION

Increase in exchange rate implies that the price of

Suppose the demand for foreign goods and services
increases (for example, due to increased
international travelling by Indians), then as depicted
in the following figure, the demand curve shifts
upward and right to the original demand curve. The
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foreign currency (dollar) in terms of domestic
currency (rupees) has increased. This is called
Depreciation of domestic currency (rupees) in terms
of foreign currency (dollars).
APPRECIATION
Similarly, in a flexible exchange rate regime, when
the price of domestic currency (rupees) in terms of
foreign currency (dollars) increases, it is called
Appreciation of the domestic currency (rupees) in
terms of foreign currency (dollars). This means that
the value of rupees relative to dollar has risen and
we need to pay fewer rupees in exchange for one
dollar.
Example of Appreciation/Depreciation
Exchange Rate Exchange Rate
(Rs/$) on (Rs/$) on
01.01.20 31.01.20
Appreciation 70 65
Depreciation 70 75
Impact of Appreciation/Depreciation on
Exports/Imports
Exports Imports
Appreciation Discouraged Encouraged
Depreciation Encouraged Discouraged
SPECULATION
Money in any country is an asset. If Indians believe
that British pound is going to increase in value
relative to the rupee, they will want to hold pounds.
Thus, exchange rates also get affected when people
hold foreign exchange on the expectation that they
can make gains from the appreciation of the
currency. This expectation in turn can actually affect
the exchange rate in the following way.
If the current exchange rate is Rs. 80 to a pound and
investors believe that the pound is going to
appreciate by the end of the month and will be
worth Rs.85, investors think if they gave the dealer
Rs. 80,000 and bought 1000 pounds, at the end of
the month, they would be able to exchange the
pounds for Rs. 85,000, thus making a profit of Rs.
5,000. This expectation would increase the demand
for pounds and cause the rupee-pound exchange
rate to increase in the present, making the beliefs
self-fulfilling.
INTEREST RATES AND THE EXCHANGE RATE
In the short run, another factor that is important in
determining exchange rate movements is the
interest rate differential i.e. the difference between
interest rates between countries.
There are huge funds owned by banks, multinational
corporations and wealthy individuals which move
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around the world in search of the highest interest
rates. If we assume that government bonds in
country A pay 8 per cent rate of interest whereas
equally safe bonds in county B yield 10 per cent, the
interest rate differential is 2 per cent. Investors
from country A will be attracted by the high interest
rates in country B and will buy the currency of
country B selling their own currency.
At the same time investors in country B will also find
investing in their own country more attractive and
will therefore demand less of country A’s currency.
This means that the demand curve for country A’s
currency will shift to the left (i.e. demand
decreases) and the supply curve will shift to the
right (i.e. supply will increase) causing a
depreciation of country A’s currency and an
appreciation of country B’s currency.
Thus, a rise in the interest rates at home often leads
to an appreciation of the domestic currency. Here,
the implicit assumption is that no restrictions exist in
buying bonds issued by foreign governments.
INCOME AND EXCHANGE RATE
When income increases, consumer spending
increases. Spending on imported goods is also likely
to increase.
When imports increase, the demand curve for
foreign exchange shifts to the right (i.e. demand will
increase). There is a depreciation of the domestic
currency (due to an appreciation in foreign
currency).
If there is an increase in income abroad as well,
domestic exports will rise and the supply curve of
foreign exchange shifts outward (i.e. supply
increases).
On balance, the domestic currency may or may not
depreciate. What happens will depend on whether
exports are growing faster than imports.
In general, other things remaining equal, a country
whose aggregate demand grows faster than the
rest of the world’s normally finds its currency
depreciating because its imports grow faster than
its exports. Its demand curve for foreign currency
shifts faster than its supply curve.
EXCHANGE RATE IN THE LONG RUN
The purchasing power parity (PPP) theory is used to
make long-run predictions about exchange rates in
a flexible exchange rate system. According to the
theory, as long as there are no barriers to trade like
tariffs (taxes on trade) and quotas (quantitative
limits on imports), exchange rates should eventually
adjust so that the same product costs the same
whether measured in rupees in India, or dollars in
the US, yen in Japan and so on, except for
differences in transportation. Over the long run,
therefore, exchange rates between any two
national currencies adjust to reflect differences in
the price levels in the two countries.
KEY DEFINITION
Flexible Exchange Rate: An exchange rate
determined through the unrestricted interaction
of supply and demand in the foreign exchange
market. Also termed floating exchange rate, this is
one of three basic exchange rate policies used by
domestic governments to control their exchange
rates with the goal of affecting international trade,
balance of trade, and balance of payments. This
policy is based on the view that the free interplay
of market forces is most likely to generate a
desireable pattern of international trade. The
other two policies are fixed exchange rate and
managed flexible exchange rate.
Appreciation: A more or less permanent increase
in value or price. "More or less permanent"
doesn't include temporary, short-term jumps in
price that are common in many markets.
Appreciation is only those price increases that
reflect greater consumer satisfaction and thus
value. While all sorts of stuff can appreciate in
value, some of the more common ones are real
estate, works of art, corporate stock, and money.
In particular, the appreciation of a nation's money
is seen by an increase in the exchange rate caused
by a growing, expanding, and healthy economy.
Depreciation: A more or less permanent decrease
in value or price. "More or less permanent"
doesn't include temporary, short-term drops in
price that are common in many markets. It's only
those price declines that reflect a reduction in
consumer satisfaction. While all sorts of stuff can
depreciate in value, some of the more common
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ones are capital, real estate, corporate stock, and
money. The depreciation of capital results from
the rigors of production and affects our economy's
ability to produce stuff. A sizable portion of our
annual investment is thus needed to replace
depreciated capital. The depreciation of a nation's
money is seen as an increase in the exchange rate.
Speculation: Buying an asset with the intent of
reselling it later at a higher price. The purpose of
speculation is simply to buy low today and sell high
tomorrow. Those who engage in speculation have
no reason for buying the asset, other than resale
at a later time. Such speculation is quite common
in most financial markets.
Purchasing Power Parity (PPP): PPP is an
economic theory that compares different
countries' currencies through a "basket of goods"
approach. According to this concept, two
currencies are in equilibrium—known as the
currencies being at par—when a basket of goods
is priced the same in both countries, taking into
account the exchange rates.
FIXED EXCHANGE RATE
In this exchange rate system, the Government fixes
the exchange rate at a particular level.
In the above figure, the market determined
exchange rate is e. However, let us suppose that for
some reason the Indian Government wants to
encourage exports for which it needs to make rupee
cheaper for foreigners it would do so by fixing a
higher exchange rate, say Rs 70 per dollar from the KEY DEFINITION
current exchange rate of Rs 50 per dollar.
Fixed Exchange Rate: A fixed exchange rate is an
Thus, the new exchange rate set by the Government exchange rate that is established at a specific level
is e1, where e1 > e. At this exchange rate, the supply and maintained through government actions
of dollars exceeds the demand for dollars. The RBI (usually through monetary policy actions of a
intervenes to purchase the dollars for rupees in the central bank). To fix an exchange rate, a
foreign exchange market in order to absorb this government must be willing to buy and sell
excess supply which has been marked as AB in the currency in the foreign exchange market in
figure. whatever amounts are necessary to keep the
exchange rate fixed.
Thus, through intervention, the Government can
maintain any exchange rate in the economy. But it Devaluation: The act of reducing the price
will be accumulating more and more foreign (exchange rate) of one nation's currency in terms
exchange so long as this intervention goes on. of other currencies. This is usually done by a
government to lower the price of the country's
On the other hand, if the government was to set an exports and raise the price of foreign imports,
exchange rate at a level such as e2, there would be which ultimately results in greater domestic
an excess demand for dollars in the foreign production. A government devalues its currency
exchange market. To meet this excess demand for by actively selling it and buying foreign currencies
dollars, the government would have to withdraw through the foreign exchange market.
dollars from its past holdings of dollars. If it fails to
do so, a black market for dollars may come up. Revaluation: The act of increasing the price
(exchange rate) of one nation's currency in terms
DEVALUATION
of other currencies. This is done by the
government if it wants to raise the price of the
In a fixed exchange rate system, when some
country's exports and lower the price of foreign
government action increases the exchange rate
imports. This is an appropriate action if the
(thereby, making domestic currency cheaper) is
country is running an undesired trade surplus with
called Devaluation.
other countries. The procedure for revaluation is
REVALUATION for the government to buy the nation's currency
and/or sell foreign currencies through the foreign
On the other hand, a Revaluation is said to occur, exchange market.
when the Government decreases the exchange rate
(thereby, making domestic currency costlier) in a
QUESTION 10
fixed exchange rate system.
Q. Consider the following statements: [1999]
Assertion (A): Devaluation of a currency may
Example of Devaluation/Revaluation
promote export.
Reason (R): Price of the country’s products in the
Exchange Rate Exchange Rate international market may fall due to devaluation.
(Rs/$) on (Rs/$) on Select the correct answer using the code given
01.01.20 31.01.20 below:
Devaluation 70 75 (a) Both A and R are true and R is the correct
Revaluation 70 65 explanation of A
(b) Both A and R are true but R is not a correct
Impact of Devaluation/Revaluation on explanation of A
Exports/Imports (c) A is true but R is false
(d) A is false but R is true
Exports Imports Answer: A
Devaluation Encouraged Discouraged
Revaluation Discouraged Encouraged

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ADVANTAGES AND DISADVANTAGES OF
FIXED EXCHANGE RATE SYSTEMS
ADVANTAGES
▪ Avoid currency fluctuations: If the value of
currencies fluctuates, significantly this can cause
problems for firms engaged in trade. For
example, if a firm is exporting, a rapid
appreciation in foreign exchange rate would
make its exports uncompetitive and therefore
may go out of business. If a firm relies on
imported raw materials, a depreciation would
increase the costs of imports and would reduce
profitability.
▪ Stability encourages investment: The
uncertainty of exchange rate fluctuations can
reduce the incentive for firms to invest in export
capacity. A fixed exchange rate provides greater
certainty and encourages firms to invest.
▪ Keep inflation low: Governments who allow
their exchange rate to depreciate may cause
inflationary pressures to occur. Depreciation of
a currency can cause inflation because aggregate
demand increases, import prices increase and
firms have less incentive to cut costs. A fixed
exchange rate, by contrast, means firms have an
incentive to keep cutting costs to remain
competitive.
DISADVANTAGES
▪ Conflict with other macroeconomic objectives:
To maintain a fixed level of the exchange rate
may conflict with other macroeconomic
objectives. If a currency is under pressure and
falling – the most effective way to increase the
value of a currency is to raise interest rates. This
will increase hot money flows and also reduce
inflationary pressures. However higher interest
rates will cause lower aggregate demand (AD)
and lower economic growth, If the economy is
growing slowly this may cause a recession and
rising unemployment.
▪ Less flexibility: In a fixed exchange rate, it is
difficult to respond to temporary shocks. For
example, if the price of oil increases, a country
which is a net oil importer will see a
deterioration in the current account balance of
payments. But in a fixed exchange rate, there is
no ability to devalue and reduce current account
deficit.
▪ Join at the wrong rate: It is difficult to know the
right rate to join at. If the rate is too high, it will
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make exports uncompetitive. If it is too low, it
could cause inflation.
▪ Require higher interest rates: If the currency is
falling below the exchange rate floor, the
government may be forced to put up interest
rates – even if this is unsuitable for the economy.
▪ Current account imbalances: Fixed exchange
rates can lead to current account imbalances. For
example, an overvalued exchange rate could
cause a current account deficit.
▪ Difficulty in keeping the value of the currency: If
a currency is falling below its band the
government will have to intervene. If
membership of a fixed exchange rate is short-
lived, it defeats the purpose and rather than
gradual changes in the exchange rate, there is
added uncertainty and speculation about the
exchange rate.
▪ Speculative Attack: The main feature of the fixed
exchange rate system is that there must be
credibility that the government will be able to
maintain the exchange rate at the level specified.
Often, if there is a deficit in the BoP, in a fixed
exchange rate system, governments will have to
intervene to take care of the gap by use of its
official reserves. If people know that the
amount of reserves is inadequate, they would
begin to doubt the ability of the government to
maintain the fixed rate. This may give rise to
speculation of devaluation. When this belief
translates into aggressive buying of one currency
thereby forcing the government to devalue, it is
said to constitute a speculative attack on a
currency. Fixed exchange rates are prone to
these kinds of attacks, as has been witnessed in
the period before the collapse of the Bretton
Woods System.
ADVANTAGES AND DISADVANTAGES OF
FLEXIBLE EXCHANGE RATE
ADVANTAGES
▪ Market Determined Rates: Freely floating
exchange rate means that the market will
determine the rate at which one currency can be
exchanged for another. The market will set these
rates on a real time basis as and when new
information flows in. This reduces the need for
an elaborate mechanism to ensure that the
exchange rates remain within a particular
range.
▪ Independence: Freely floating exchange rates
allow the governments and central banks of a
 nation to have a great degree of independence.
For instance, when the dollar raises its interest
rates, all currencies pegged to it also have to
make necessary changes. Hence, the countries
that have their currencies pegged to the dollar
have limited independence whereas countries
that let their currencies float have a far greater
degree of independence.
▪ Less Probability of Speculative Attacks: A freely
floating currency faces adjustment on a minute
to minute basis. The point is that speculative
attacks happen only when the currency remains
stagnant at a given point whereas its underlying
fundamentals have changed. It is then that the
speculators see an opportunity to bring the
currency to its equilibrium point quickly and
make a quick buck by doing so. However, if the
currency is traded on the Forex market as a freely
floating currency, adjustments happen on a
minute to minute basis. Therefore, the gap
between the underlying fundamentals and the
market value never really widens up enough for
the speculators to mount a sudden attack.
▪ Low Requirement of Reserves: A freely floating
exchange system does not require the central
bank to hold massive reserves. This is because
the Central Bank does not have to conduct
active trading operations in order to maintain
the value of the currency. Central Bank
operations are a very rare event for countries
that have a floating rate system. This is a major
advantage of this system since holding foreign
exchange for trading purposes is an expensive
strategy. Firstly, it requires the country to
maintain a huge currency reserve. Then, it also
requires the central bank to have an active
trading desk 24 by7! The floating rate system is
simply a lot more convenient since it does not
have any such requirements.
DISADVANTAGES
▪ Uncertainty: Firstly, a freely floating currency
rate implies a lot of volatility. The value of
currencies changes on a real time basis. Also,
since Forex market is not regulated, currency
values could skyrocket or hit rock bottom in a
matter of minutes. In the short run, traders find
it difficult to engage in foreign trade since they
are not aware of the exact prices that their goods
will fetch them. Movements in the currency
market can cause a significant dent in the profits
of companies which indulge in foreign trade.
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However, these risks can be managed with tools
like hedging.
▪ Allocation of Resources: At a macro level, the
economy faces a problem while allocating
resources. This is because as exchange rates
change so does the benefit that can be derived
from resources. For instance, a rising exchange
rate makes imports a better option whereas a
falling rate makes exports easier. Hence, if
exchange rate keeps of fluctuating, the country
cannot really create a long-term strategy and
stick to it. The allocation of resources is
optimized in the short run. However, in the long
run, this allocation seems to be ad-hoc since it
does not follow any given plan.
▪ Lack of Discipline: Lastly, freely floating
exchange rates only make sense if the country
has sufficient internal control mechanisms in
place. Hence, if there is likelihood that the
monetary policy may be misused for personal
gains by a group of influential people, then it is
better to peg the currency to another more
developed currency. In this way, fiscal discipline
is imposed on the economy. Freely floating
currencies provide independence. However, the
independence can only be utilized if the
economy is disciplined enough.
MANAGED FLOATING (MANAGED FLEXIBLE
EXCHANGE RATE)
A managed flexible exchange rate is a combination
of two other exchange rate policies -- fixed and
flexible. It recognizes the benefits of a flexible
exchange rate automatically adjusting to
equilibrium in response to foreign exchange market
disruptions. However, it also recognizes that the
resulting exchange rate might not always generate
desired international trade patterns and that
government might need to step in to fix the rate
temporarily.
A managed float exchange rate policy is much like a
mother who allows her young son to play outside but
does not allow him to leave the backyard. Freely
playing in the backyard is the flexible part and not
leaving the backyard is the managed/fixed part.
This policy evolved from the historical inclination of
most nations to fix exchange rates, which was then
countered with the theoretical benefits of
unrestricted flexible exchange rates. Nations have
been prone to fix exchange rates above equilibrium
levels as a means of encouraging exports and
discouraging imports. But this strategy cannot be
simultaneously undertaken by all nations and is STEPS THAT CAN BE TAKEN TO CONTROL
TOO MUCH DEPRECATION
usually detrimental to global trade.
▪ RBI can start supplying US dollars in the market
A flexible exchange rate policy is generally more
to cool down the exchange rate. Increase in
efficient and lessens the likelihood of global trade
supply of US dollars will pull down the price of
conflicts. However, problems can occur if exchange
US dollars (FOREX Rate) in the Indian FOREX
rates rise or fall substantially in a short period. As
market. In other words, depreciation of rupee
such, governments step in to limit exchange rate
against US dollar will be checked.
changes, keeping them within "acceptable" bounds,
▪ The second measure which can be taken is to talk
keeping them from leaving the backyard where they
the market down. In the situation of
might run into a street and be injured by a moving
depreciation, there is a tendency for importers
vehicle.
to rush in to buy dollars and exporters to hold
back remitting their earnings on the expectation
With a managed float, the foreign exchange markets
that the rupee will depreciate further. This
carry on normal day-to-day activity as exports,
exacerbates the demand-supply matrix for
imports, investors, and speculators buy and sell the
foreign currency and drives down the rupee
currencies needed to conduct their business
further. The RBI can ensure that export earnings
activities. If, however, an exchange rate looks to be
come back to the country on time while
rising or falling too much, moving outside the range
importers should be urged not to rush in to buy
that the policy players deem acceptable, then they
dollars in advance. Alternatively, asking the
are likely to step into the fray, doing whatever
importers to hedge can be attempted though it
buying and selling of currency is necessary to keep
cannot be made mandatory. Making such
the exchange within bounds.
statements will help lower the speculative
element which comes into the picture every time
Suppose, for example, that the Reserve Bank of India
the rupee keeps falling.
and Government of India officials by consensus
▪ Third, the government should focus on exports
decide that an exchange rate of Rs 70 (+/- 3) per US
and to the extent possible, especially on the tax
dollar is a fair exchange rate. If the exchange rate is
credit/refund part, clear the coast for exporters.
floating within this band, no action will be taken to
SMEs (small and medium enterprises) which are
affect it. However, if the exchange rate starts to
dominant in the export market have had tax
diverge beyond the limits in either direction, action
refund issues and this needs to be sorted out.
will be taken to restore it within the band.
Also, export finance is another problem which
has been bothering exporters and impediments
KEY DEFINITION
on this front too need to be removed. But this
will work only in the medium term and cannot
Managed Flexible Exchange Rate: A managed
deliver result immediately because export
flexible exchange rate, what is also termed a
markets tend to be relatively inelastic and are
managed float, is an exchange rate that is
driven by demand factors.
generally allowed to adjust due to the interaction
▪ RBI would have to monitor the other
of supply and demand in the foreign exchange
components of demand for dollars to ensure
market, but with occasional intervention by
that there are limits to the drawal of dollars for
government. Most nations of the world currently
other purposes such as travel, investment, and
use a managed flexible exchange rate policy. With
education.
this alternative an exchange rate is free to rise and
▪ Channels for external commercial borrowing
fall, but it is subject to government control if it
should be looked at judiciously. While urging
moves too high or too low. With managed float,
companies to explore the market makes sense,
the government steps into the foreign exchange
it should be noted that un-hedged positions can
market and buys or sells whatever currency is
put on pressure on debt servicing. Nevertheless,
necessary keep the exchange rate within desired
in these conditions, such borrowings would be
limits.
helpful.
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▪ Channel for considering a sovereign bond or any
such scheme for getting expatriates to invest in
such bonds should be planned in advance —
which may not be required if conditions stabilise.
▪ Capital flows need to be monitored proactively
and this is where FPIs (foreign portfolio
investments) matter. The strong inflow of FPIs
has the power to rein in the rupee.
QUESTION 11
Q. Consider the following statements: [1998]
The price of any currency in international market
is decided by the:
1. World Bank
2. Demand for goods/services provided by the
country concerned
3. Stability of the government of the concerned
country
4. Economic potential of the country in question
Select the correct answer using the code given
below:
(a) 1, 2, 3 and 4 are correct
(b) 2 and 3 are correct
(c) 3 and 4 are correct
(d) 1 and 4 are correct
Answer: B
QUESTION 12
Q. Which one of the following is not the most
likely measure the Government/RBI takes to stop
the slide of Indian rupee? [2019]
(a) Curbing imports of non-essential goods and
promoting exports
(b) Encouraging Indian borrowers to issue rupee
denominated Masala Bonds
(c) Easing conditions relating to external
commercial borrowing
(d) Following an expansionary monetary policy
Answer: D
NOMINAL AND REAL EXCHANGE RATE
NOMINAL EXCHANGE RATE
The nominal exchange rate is defined as:
The number of units of the domestic currency that
are needed to purchase a unit of a given foreign
currency.
For example, if the value of the US Dollar in terms of
the INR is 70, this means that the nominal exchange
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rate between the dollar and the rupee is 70. We
need to give 70 rupees to buy one dollar.
It’s called nominal, because it takes into account
only the numerical value of the currencies. It
doesn’t take into account the purchasing power of
the currencies. There is another exchange rate called
“real exchange rate” that takes the purchasing
power into account.
REAL EXCHANGE RATE
The real exchange rate is a bit more complicated
than the nominal exchange rate. While the nominal
exchange rate tells how much foreign currency can
be exchanged for a unit of domestic currency, the
real exchange rate tells how much the goods and
services in the domestic country can be exchanged
for the goods and services in a foreign country.
The difference between the nominal and the real
exchange rate is that the real exchange rate takes
into account the domestic and foreign prices, as
summarized in the following formula:
Real exchange rate can be defined as the rate that
takes into account inflation differential between
the countries. Suppose the rupee was trading at Rs
70 to a dollar at the beginning of 2019. Assuming a
10% inflation in the Indian economy and 5%
inflation in the US economy for the whole year, then
this model says the rupee should depreciate by 5%
(10%-5%) to Rs 73.50 to a dollar, other things being
equal.
EXCHANGE RATE MANAGEMENT IN
INDIA
THE INDIAN EXPERIENCE
▪ India’s exchange rate policy has evolved in line
with international and domestic developments.
▪ Post-independence, in view of the prevailing
Bretton Woods system, the Indian rupee was
pegged to the pound sterling due to its historic
links with Britain. A major development was the
devaluation of the rupee by 36.5 per cent in June,
1966. With the breakdown of the Bretton
Woods system, and also the declining share of
 UK in India’s trade, the rupee was delinked from
the pound sterling in September 1975.
▪ During the period between 1975 to 1992, the
exchange rate of the rupee was officially
determined by the Reserve Bank within a
nominal band of plus or minus 5 per cent of the
weighted basket of currencies of India’s major
trading partners.
▪ The Reserve Bank intervened on a day-to-day
basis which resulted in wide changes in the size
of reserves. The exchange rate regime of this
period can be described as an adjustable nominal
peg with a band.
▪ The beginning of 1990s saw significant rise in oil
prices and suspension of remittances from the
Gulf region in the wake of the Gulf crisis. This,
and other domestic and international
developments, led to severe balance of
payments problems in India.
▪ The drying up of access to commercial banks and
short-term credit made financing the current
account deficit difficult.
▪ India’s foreign currency reserves fell rapidly
from US $ 3.1 billion in August to US $ 975
million on July 12, 1991 (we may contrast this
with the present; as of December 06, 2019,
India’s foreign exchange reserves stand at US $
453 billion).
▪ Apart from measures like sending gold abroad,
curtailing non-essential imports, approaching
the IMF and multilateral and bilateral sources,
introducing stabilisation and structural reforms,
there was a two-step devaluation of 18–19 per
cent of the rupee on July 1 and 3, 1991.
▪ In march 1992, the Liberalised Exchange Rate
Management System (LERMS) involving dual
exchange rates was introduced. Under this
system, 40 per cent of exchange earnings had to
be surrendered at an official rate determined by
the Reserve Bank and 60 per cent was to be
converted at the market determined rates.
▪ The dual rates were converged into one from
March 1, 1993; this was an important step
towards current account convertibility, which
was finally achieved in August 1994 by accepting
Article VIII of the Articles of Agreement of the
IMF.
▪ The exchange rate of the rupee thus became
market determined, with the Reserve Bank
ensuring orderly conditions in the foreign
exchange market through its sales and
purchases.
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QUESTION 13
Q. Consider the following statements: [2000]
Assertion (A): The rate of growth of India’s exports
has shown an appreciable increase after 1991.
Reason (R): The Govt. of India has resorted to
devaluation.
Select the correct answer using the code given
below:
(a) Both A and R are true and R is the correct
explanation of A
(b) Both A and R are true but R is not a correct
explanation of A
(c) A is true but R is false
(d) A is false but R is true
Answer: A
CONVERTIBILITY OF RUPEE
CONCEPT OF CONVERTIBILITY
Convertibility of currency means when currency of a
country can be freely converted into foreign
exchange at market determined rate of exchange.
For example, convertibility of rupee means that
those who have foreign exchange (e.g. US dollars,
Pound Sterling etc.) can get them converted into
rupees and vice-versa at the market determined
rate of exchange.
QUESTION 14
Q. Convertibility of rupee implies [2015-I]
(a) being able to convert rupee notes into gold
(b) allowing the value of rupee to be fixed by
market forces
(c) freely permitting the conversion of rupee to
other currencies and vice versa
(d) developing an international market for
currencies in India
Answer: C
CONCEPT OF CURRENT ACCOUNT
CONVERTIBILITY
Current account convertibility means when foreign
exchange (e.g. Pound Sterling, U.S.Dollar etc)
received for export of merchandise and services can
be freely converted into Indian rupees and vice-
versa in case of imports.
At the beginning of the 1991 ‘LPG’ reforms, the
rupee was made partially convertible for goods,
services, and merchandise only. During the mid-
1990s, the rupee was fully made current account
convertible for all trading activities, remittances,
and invisibles.
CONCEPT OF CAPITAL ACCOUNT
CONVERTIBILITY
By capital account convertibility we mean that in
respect of capital flows (that is, flows of portfolio
capital, direct investment flows, flows of borrowed
funds) a currency is freely convertible into foreign
exchange and vice-versa at market determined
exchange rate.
Rupee continues to remain capital account non-
convertible. One can still bring in foreign capital or
take out local money for these purposes, but there
are ceilings imposed by the government that
require approvals.
QUESTION 15
Q. The Capital Account Convertibility of the
Indian Rupee implies: [1998]
(a) that the Indian Rupee can be exchanged by the
authorised dealers for travel
(b) that the Indian Rupee can be exchanged for
any major currency for the purpose of trade in
goods and services
(c) that the Indian Rupee can be exchanged for any
major currency for the purpose of trading financial
assets
(d) None of the above
Answer: C
IS INDIAN NATIONAL RUPEE CONVERTIBLE?
Until the early 1990s (pre-reform period), anyone
willing to transact in a foreign currency would need
permission from the Reserve Bank of India (RBI),
regardless of the purpose. People wanting to engage
in foreign travel, foreign studies, the purchase of
imported goods, or to get cash for foreign currencies
received (like with exports) were all required to go
through the RBI. All such forex exchanges occurred
at pre-determined forex rates finalized by the RBI.
After liberal economic reforms were introduced in
1991, many significant developments occurred that
impacted the way forex transactions were
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conducted. Exporters and importers were allowed
to exchange foreign currencies for the trade of
unbanned goods and services, there was easy access
to forex for studying or traveling abroad, and a
relaxation on foreign business and investments with
minimal (or no) restrictions depending on the
industry sectors.
However, Indians still require regulatory approval if
they want to invest an amount above a pre-
determined threshold level for the purpose of
investments or purchasing assets overseas. Similarly,
incoming foreign investments in certain sectors like
insurance or retail are capped at a specific
percentage and require regulatory approvals for
higher limits.
As of 2019, the Indian rupee is a partially convertible
currency. This means that although there is a lot of
freedom to exchange local and foreign currency at
market rates, a few important restrictions remain
for higher amounts, and these still need approval.
The regulators also intervene from time-to-time to
keep the exchange rates within permissible limits
instead of keeping the INR as a completely free-
floating currency left to market dynamics. In the case
of extreme volatility in rupee exchange rates, the
RBI swings into action by purchasing/selling U.S.
dollars (kept as foreign reserve) to stabilize the
rupee.
Full convertibility would mean the rupee exchange
rate would be left to market factors without any
regulatory intervention. There may be no limit on
inflow or outflow of capital for various purposes
including investments, remittances, or asset
purchases/sales.
QUESTION 16
Q. Consider the following statements: [2000]
The Indian rupee is fully convertible:
1. in respect of Current Account of Balance of
payment
2. in respect of Capital Account of Balance of
payment
3. into gold
Which of these statements is/are correct?
(a) 1 alone
(b) 3 alone
(c) 1 and 2
(d) 1, 2 and 3
Answer: A

QUESTION 17
Q. Consider the following statements: [2002]
Full convertibility of the rupee may mean:
1. Its free float with the international currencies
2. Its direct exchange with any other international
currency at any prescribed place inside and
outside the country
3. It acts just like any other international currency
Which of these statements are correct?
(a) 1 and 2
(b) 1 and 3
(c) 2 and 3
(d) 1, 2 and 3
Answer: D
ADVANTAGES OF A FULLY CONVERTIBLE
CURRENCY
▪ Sign of Stable and Mature Markets: Regulators
like to keep control over their territories. Free
and open entry to an enormous number of global
market participants would increase the risk of
losing regulatory control due to large market size
and a huge flow of capital. Opening up to a fully
convertible currency is a solid sign that a country
and its markets are stable and mature enough
to handle the free and unrestricted movement
of capital, which attracts investments making
the economy better.
▪ Increased Liquidity in Financial Markets: Full
capital account convertibility opens up the
country’s markets to global players including
investors, businesses, and trade partners. This
allows easy access to capital for different
businesses and sectors, positively impacting a
nation’s economy.
▪ Improved Employment and Business
Opportunities: With increased participation
from global players, new businesses, strategic
partnerships, and direct investments flourish. It
also helps in the creation of new employment
opportunities across various industry sectors, as
well as nurturing entrepreneurship for new
businesses.
▪ Onshore Rupee Market Development: The
growing international interest in the Indian
rupee is evident from the development of
offshore rupee markets in locations like Dubai,
London, New York, and Singapore. Trading of the
INR is still far lower than other currencies such as
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the euro. In 2018, INR contracts traded against
the dollar an average of 11,666 times per day
compared to 193,512 contracts converted from
Euro to USD. Making the rupee fully convertible
would enable greater trades and global flow of
the Indian currency, helping national markets
with improved liquidity, better regulatory
purview, and reduced dependence and risks
from offshore market participants.
▪ Easy Access to Foreign Capital: Local businesses
can benefit from easy access to foreign loans at
comparatively lower costs—lower interest
rates. Indian companies currently have to take
the ADR/GDR route to list on foreign exchanges.
After full convertibility, they will be able to
directly raise equity capital from overseas
markets.
▪ Better Access to a Variety of Goods and
Services: Amid current restrictions, one does not
see much variety in India for foreign goods and
services. Walmart (WMT) and Tesco stores aren’t
that common, although a handful exist in
partnership with local retail chains. Full
convertibility will open doors for all global
players to the Indian market, making it more
competitive and better for consumers and the
economy alike.
▪ Progress in Multiple Industry Sectors: Sectors
like insurance, fertilizers, retail, etc. have
restrictions on foreign direct investments
(FDIs). Full convertibility will open the doors of
many big international players to invest in these
sectors, enabling much-needed reforms and
bringing variety to the Indian masses.
▪ Outward Investments: Fancy buying a house on
the coast of Florida or buying a million-dollar
yacht in London? At present, any Indian
individual or business would need permission
from authorities to do so. After full convertibility,
there will be no limits on the amounts
exchanged and no need for approvals.
▪ Improved Financial System: The Tarapore
Committee, which was tasked with assessing the
full convertibility of the rupee, has noted these
benefits after full rupee convertibility, including:
✓ Indian businesses will be able to issue foreign
currency-denominated debt to local Indian
investors.
 ✓ Indian businesses will be able to hold foreign
currency deposits in local Indian banks for
capital requirements.
✓ Indian banks will be able to borrow and/or
lend to foreign banks in foreign currencies.
✓ Easy options to buy/sell gold freely and offer
gold-based deposits and loans with higher
(or even uncapped) limits.
DISADVANTAGES OF A FULLY CONVERTIBLE
CURRENCY
▪ High Volatility: Amid a lack of suitable regulatory
control and rates subject to open markets with a
large number of global market participants, high
levels of volatility, depreciation, or appreciation
in forex rates may happen, challenging the
country’s economy.
▪ Foreign Debt Burden: Businesses can easily
raise foreign debt, but they are prone to the risk
of high repayments if exchange rates become
unfavorable. Imagine an Indian business taking a
U.S. dollar loan at a rate of 4%, compared to one
available in India at 7%. However, if the U.S.
dollar appreciates against the Indian rupee, more
rupees will be needed to get the same number of
dollars, making the repayment costly.
▪ Effects on Balance of Trade and Exports: A
rising, unregulated rupee makes Indian exports
less competitive in the international markets.
Export-oriented economies like India and China
prefer to keep their exchange rates lower to
retain the low-cost advantage. Once the
regulations on exchange rates go away, India
risks losing its competitiveness in the
international market.
▪ Lack of Fundamentals: Full capital account
convertibility has worked well in well-regulated
nations that have a robust infrastructure in
place. India’s basic challenges—a high
dependence on exports, burgeoning
population, corruption, socio-economic
complexities, and challenges of bureaucracy—
may lead to economic setbacks post-full rupee
convertibility.
INDIA’S FOREX RESERVES
WHAT ARE FOREX RESERVES?
Most countries have adopted the definition
suggested by the International Monetary Fund
(Balance of Payments Manual, and Guidelines on
Foreign Exchange Reserve Management, 2001);
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which defines forex reserves as external assets that
are readily available to and controlled by monetary
authorities for direct financing of external
payments imbalances, for indirectly regulating the
magnitudes of such imbalances through
intervention in exchange markets to affect the
currency exchange rate, and/or for other purposes.
RBI ACT 1934 AND FOREX RESERVES
In India, the Reserve Bank of India Act 1934 contains
the enabling provisions for the RBI to act as the
custodian of foreign reserves, and manage reserves
with defined objectives. The powers of being the
custodian of foreign reserves is enshrined, in the first
instance, in the preamble of the Act. The ‘reserves’
refer to both foreign reserves in the form of gold
assets in the Banking Department and foreign
securities held by the Issue Department, and
domestic reserves in the form of ‘bank reserves’.
The composition of foreign reserves is indicated, a
minimum reserve system is set out, and the
instruments and securities in which the country’s
reserves could be deployed are spelt out in the
relevant Sections of the RBI Act.
OBJECTIVES OF HOLDING FOREX RESERVES
▪ Maintaining confidence in monetary and
exchange rate policies.
▪ Enhancing capacity to intervene in forex
markets.
▪ Limiting external vulnerability by maintaining
foreign currency liquidity to absorb shocks
during times of crisis including national disasters
or emergencies.
▪ Providing confidence to the markets especially
credit rating agencies that external obligations
can always be met, thus reducing the overall
costs at which forex resources are available to
all the market participants.
▪ Adding to the comfort of the market
participants, by demonstrating the backing of
domestic currency by external assets.
At a formal level, the objective of reserve
management in India could be found in the RBI Act,
where the relevant part of the preamble reads as ‘to
use the currency system to the country’s advantage
and with a view to securing monetary stability’.
COMPONENTS OF INDIA'S FOREIGN
EXCHANGE RESERVES
▪ Foreign currency assets (FCAs): The foreign
currencies which are held as forex reserves
include US dollar, Euro, British pound sterling,
Japanese yen and Chinese Yuan.
▪ Special Drawing Rights with IMF: Special
drawing rights, or SDR, are an artificial currency
instrument created by the International
Monetary Fund, which uses them for internal
accounting purposes. The value of the SDR is
calculated from a weighted basket of major
currencies, including the U.S. dollar, the euro,
Japanese yen, Chinese yuan, and British pound.
SDR interest rate (SDRi) provides the basis for
calculating the interest rate charged to member
countries when they borrow from the IMF and
paid to members for their remunerated creditor
positions in the IMF.
▪ Gold reserves
▪ Reserve Bank of India's reserve position with
the IMF: Reserve tranche is a portion of the
required quota of currency each member
country must provide to the International
Monetary Fund (IMF) that can be utilized for its
own purposes.
(d) Both ADR and SDR
Answer: C
QUESTION 19
Q. Which one of the following groups of items is
included in India’s foreign-exchange reserves?
[2013 - I]
(a) Foreign-currency assets, Special Drawing
Rights (SDRs) and loans from foreign countries
(b) Foreign-currency assets, gold holdings of the
RBI and SDR’s
(c) Foreign-currency assets, loans from the World
Bank and SDRs
(d) Foreign-currency assets, gold holdings of the
RBI and loans from the World Bank
Answer: B

The largest component of the Foreign Exchange

Reserves constitutes of foreign currency assets
(FCAs). Changes in FCAs occurs due to the selling and
purchasing of foreign exchange by the Reserve Bank
of India, externally received income of the
Government of India from the deployment of foreign
exchange reserves and income due to the
revaluation of assets.

Forex reserves, as on January 10, 2020 are as

follows:

QUESTION 18
Q. Which of the following is/are treated as
artificial currency? [2010]
(a) ADR
(b) GDR
(c) SDR

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 1. Increase in Indian imports.
MCQS FOR PRACTICE 2. Rise in interest rates of Government of India
bonds.
Q.1 In the context of Indian economy, which of the Select the correct answer using the code given
following constitute export of services? below:
1. An Indian tourist visiting Mauritius. (a) 1 only
2. Bharti Airtel setting up its operations in Africa. (b) 2 only
3. An Indian IT company selling software to a (c) Both 1 and 2
Chinese firm. (d) Neither 1 nor 2
4. A Pakistani national visiting India for liver
transplant.
Select the correct answer using the code given
below:
(a) 1, 2, and 3 only
(b) 4 only
(c) 2, 3 and 4 only
(d) 2 and 4 only

Q. 2 With reference to economy, the term 'Autarky'

is best described by which of the following?
(a) A closed economy
(b) An open economy
(c) A floating exchange rate
(d) A fixed exchange rate

Q.3 Consider the following statements regarding

capital and current account of Balance of Payments:
1. The current account has a direct effect on the
flow of income in a country.
2. The capital account influences the volume of
assets which a country holds.
Which of the statements given above is/are correct?
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

Q.4 Which of the following items are part of

'current account' in Balance of Payments?
1. Interest on loans
2. Tourist expenditure
3. Banking and insurance charges
4. Software services
Select the correct answer using the code given
below:
(a) 1, 2, 3 and 4
(b) 2, 3, and 4 only
(c) 1 and 3 only
(d) 1, 2 and 4 only

Q.5 Which of the following conditions can lead to

depreciation of Indian Rupee?
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MCQS WITH ANSWER AND
EXPLANATION
Q.1 In the context of Indian economy, which of the
following constitute export of services?
1. An Indian tourist visiting Mauritius.
2. Bharti Airtel setting up its operations in Africa.
3. An Indian IT company selling software to a
Chinese firm.
4. A Pakistani national visiting India for liver
transplant.
Select the correct answer using the code given
below:
(a) 1, 2, and 3 only
(b) 4 only
(c) 2, 3 and 4 only
(d) 2 and 4 only
Answer: C
Explanation:
Services export means an activity which earns
foreign exchange for the home country, and which is
included within the services sector. In this case, the
first option is included within the services sector but
it would result in outflow of foreign exchange.
In rest of the three cases the activities are included
in services sector and are earners of foreign
exchange for India.
Q. 2 With reference to economy, the term 'Autarky'
is best described by which of the following?
(a) A closed economy
(b) An open economy
(c) A floating exchange rate
(d) A fixed exchange rate
Answer: A
Explanation:
Autarky is the quality of being self-sufficient. Usually
the term is applied to political states or their
economic systems. Autarky exists whenever an
entity can survive or continue its activities without
external assistance or international trade. Another
term for closed economy is Autarky.
Today, complete economic autarkies are rare. A
possible example of a current autarky is North Korea.
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However, even North Korea has extensive trade with
the Russian Federation, the People's Republic of
China, Syria, Iran,Vietnam, and many countries in
Europe and Africa.
Q.3 Consider the following statements regarding
capital and current account of Balance of Payments:
1. The current account has a direct effect on the
flow of income in a country.
2. The capital account influences the volume of
assets which a country holds.
Which of the statements given above is/are correct?
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2
Answer: C
Explanation:
The current account deals with payment for
currently produced goods and services. It includes
also interest earned or paid on claims and also gifts
and donations.
In other words, current account receipts have the
effect of increasing the flow of income in the
country. On the other hand, when India imports
goods and services from foreign countries and pays
them money which would have been used to
demand goods and services within the country
money flows out to foreign countries.
The capital account, on the other hand, deals with
capital receipts and payments of debts and claims.
The capital account, however, does not have such a
direct effect on the level of income; it influences the
volume of assets which a country holds.
Hence, both the statements are correct.
Q.4 Which of the following items are part of
'current account' in Balance of Payments?
1. Interest on loans
2. Tourist expenditure
3. Banking and insurance charges
4. Software services
Select the correct answer using the code given
below:
(a) 1, 2, 3 and 4
(b) 2, 3, and 4 only
(c) 1 and 3 only
(d) 1, 2 and 4 only
Answer: A an appreciation of Rupee. Thus, a rise in the interest
rates at home often leads to an appreciation of the
Explanation: domestic currency. Here, the implicit assumption is
Both visible and invisible items together make up the that no restrictions exist in buying bonds issued by
current account. Interest on loans, tourist foreign governments. Hence, statement 2 is not
expenditure, banking and insurance charges, correct.
software services etc., are similar to visible trade
since receipts from selling such services to the
foreigners are very similar in their effects to the
receipts from sales of goods; both provide income to
the people who produce the goods or services.

Thus, Balance of payments on current account is

more comprehensive in scope than balance of trade.
It includes not only imports and exports of goods
which are visible items but also invisible items such
as foreign travel, transportation (shipping, air
transport etc.), insurance, tourism, investment
income (e.g. interest on investments), transfer
payments i.e. donations, gifts, software services, etc.

Q.5 Which of the following conditions can lead to

depreciation of Indian Rupee?
3. Increase in Indian imports.
4. Rise in interest rates of Government of India
bonds.
Select the correct answer using the code given
below:
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2
Answer: A

Explanation:
When imports increase, the demand curve for
foreign exchange shifts to the right. There is a
depreciation of the domestic currency. Hence,
statement 1 is correct.

There are huge funds owned by banks, multinational

corporations and wealthy individuals which move
around the world in search of the highest interest
rates. If we assume that government bonds in China
pay 8 per cent rate of interest whereas equally safe
bonds in India yield 10 per cent. Investors from China
will be attracted by the high interest rates in India
and will buy the Indian currency (Rupee) selling their
own currency. At the same time Indian investors will
also find investing in India more attractive and will
therefore demand less of country Chinese currency.
This will cause a depreciation of China‘s currency and

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