UNIT -II

Foreign Exchange Rate and Balance of

Payments Important Questions for class
12 economics Foreign Exchange Rate
1. Foreign Exchange It refers to the reserve of foreign currencies.
e.g. INR is Indian currency except that all other currency will be foreign exchange for
India.

2. Foreign Exchange Rate It is the rate at which one currency can be exchanged
for the other currency in foreign exchange market, e.g. ? 58 are to be paid to buy
one dollar, then the t/ $ (Rupees per dollar) exchange rate is 58 i.e. ?58 per $ .

3.Exchange Rate System

(i) Fixed exchange rate system It is a system in which the central authority or
government maintains their exchange rate fixed either against gold or some other
currency. Fixed exchange rate has two important types:
(a) Gold standard Under gold standard, a country’s Central Bank fixes its currency
against certain quantity of gold.
(b) Bretton woods system Under this system, Central Bank ties its currency with
USD, as the official reserve asset.
(ii) Flexible Exchange Rate System The rate of exchange which is determined by
the market forces of demand and supply of foreign currencies in the foreign
exchange market, is termed as flexible exchange rate system. Flexible exchange
rate system has two main types:
(a)Clean floating system Under this system, exchange rate is freely determined by
the market forces of demand and supply of foreign exchange with no interference by
the central authority.
(b) Managed floating system Under this system, exchange rate is determined by
the market forces of demand and supply of foreign exchange and the excessive
fluctuation is checked by the central authority, it is also termed as dirty floating.

4. Merits of Fixed Exchange Rate System

(i) Minimise exchange rate fluctuations
(ii) Reduces volatility and fluctuations in prices
(iii)Imposes discipline on the monetary authority
(iv) Encourages international trade and investment flows
(v) Less speculation in the currency market
5. Demerits of Fixed Exchange Rate System
(i) Central Bank needs to hold huge stocks of either Gold or USD.
(ii) Do not allow for automatic stabilisation of exchange rate.
(iii) Diverts Central Banks focus from economic problems to exchange rate
(iv) It discourages venture capital.
(v) These exist the possibility of policy delay.

6. Merits of Flexible Exchange Rate System

(i) Independent monetary policy
(ii) Encourages international mobility of capital and trade
(iii) Encourages venture capital
(iv) No need to maintain huge stock of gold or other currency

7. Demerits of Flexible Exchange Rate System

(i) Creates the condition of instability in the international trade
(ii) Adverse effect on economic structure
(iii) Unnecessary capital movements
(iv) Inflationary problems
(v) Difficulty in policy formation

8. Different Concepts of Foreign Exchange Rate

(i) Nominal exchange rate It refers to the number of units of domestic currency, one
must give up to get an unit of foreign currency. In simple term, it refers to the price of
foreign currency in terms of domestic currency.
(ii) Real exchange rate The real exchange rate is the ratio of foreign to domestic
prices, measured in the same currency. It is defined as

(iii) Nominal Effective Exchange Rate (NEER) It is that type of effective exchange
rate which does not account for change in price level while measuring average
strength of one currency in relation to the other.
(iv) Real Effective Exchange Rate (REER) It is that type of effective exchange rate
which accounts for changes in the price level across different countries of the world.

9. Sources of Demand for Foreign Exchange

(i) Payment of loans and interest to international organisations
(ii) Gifts and grants to rest of the world
(iii) Foreign investment across the world
(iv)Foreign trade i.e. Imports
(v) Foreign exchange trade for speculation
(vi) Foreign tourism

10. Sources of the Supply of Foreign Exchange

(i) Exports of goods and services from domestic country
(ii) Foreign investment
(a) Foreign direct investment
(b) Portfolio
(iii)Foreign tourism from abroad.
(iv)Purchases by non-residents in the domestic country.
(v) Remittances from abroad
Determination of Exchange Rate Exchange rate is determined by the demand and
supply forces of foreign exchange in foreign exchange market.
Determination of Equilibrium Rate of Exchange The equilibrium exchange rate is
obtained at the point where supply of foreign exchange equakb,.tp the demand for
foreign exchange.

Some Important Terms Related to Foreign Exchange Market

(i) Foreign exchange market It is that market where exchange of foreign currencies
took place. The major participants in this market are commercial banks, brokers,
other authorised dealers, etc.
(ii) Functions of foreign exchange market
(a) Transfer function
(b) Credit function
(c) Hedging function
(iii) Forward market It refers to that market which covers sale and purchase of
foreign exchange for future delivery, at a rate decided today.
(iv) Spot market The market which handles only spot transactions or current
transactions of foreign exchange are termed as spot market or current market.
Some Important Terms Related to Foreign Exchange Rate
(i) Appreciation of currency When the value of domestic currency increases in
relation to a foreign currency due to demand and supply forces in the free market, it
is termed as appreciation of the domestic currency, (under flexible exchange rate
system.)
(ii)Depreciation of currency Depreciation of domestic currency occurs when the
value of domestic currency decreases in relation to the value of foreign currency
(under flexible exchange rate system) .
(iii) Revaluation of currency Revaluation is the rise in the value of domestic
currency in relation to foreign currency as planned by Central Bank in a situation
when exchange rate is not determined by market forces of demand and supply
(under fixed exchange rate system.)
(iv) Devaluation of currency Devaluation is the fall in the value of domestic
currency in relation to foreign currency as planned by the Central Bank in a situation
when exchange rate is not determined by forces of demand and supply under fixed
exchange rate system.
(v) Spot exchange rate It refers to that situation where exchange rate is determined
on spot. However, actual transaction may take 1 day or 2 to get settled.
(vi) Forward exchange rate Under this system, exchange rate is determined on
some specified future date at a rate decided at present.
Previous Years Examination Questions
1 Mark Questions

1. Give the meaning of managed floating exchange rate. (All India 2014; Delhi
2012)
Ans. The system of adjusting the exchange rates as per the rules and regulations of
foreign exchange market is termed as managed floating.

2. Define foreign exchange rate. (All India 2014:1 Delhi 2011)

Ans. Foreign exchange rate refers to the rate at which one currency can be
exchanged for the other currency in foreign exchange market, e.g. if Rs. 58 is paid to
buy one US dollar, then Rs./$ exchange rate will be 58 i.e. Rs.58 per dollar.

3. What is floating exchange rate? (All India 2014)

or
Define flexible exchange rate system. (Delhi 2008)
Ans. The rate of exchange which is determined by the market forces of demand and
supply of foreign currencies in the foreign exchange market, is termed as flexible
exchange rate system.

4. What is a fixed exchange rate? (Ail India 2013)

or
Give the meaning of fixed foreign exchange rate.(All India 2012,2009,2008;
Delhi 2009)
Ans. Fixed exchange rate is the system under which the central authority or
government maintains their exchange rate fixed either against gold or some other
foreign currency, (say USD)

5. What is foreign exchange? (All India 2011; Delhi 2009c)

or
Give meaning of foreign exchange. (Delhi 2009c)
Ans.Foreign exchange refers to the reserve of foreign currency with a country, e.g.
currency of US and UK are the foreign exchanges for India.

6. State two sources of supply of foreign exchange. (Delhi 2010)

Ans. Two sources of supply of foreign exchange are:
(i) Export of goods and services from domestic country to foreign country.
(ii) Foreign direct investment.

7. State two sources of demand for foreign exchange. (All India 2010)
Ans. Two sources of demand for foreign exchange are
(i) Payment of loans and interest to international organisations.
(ii) Gifts and grants to rest of the world.
3 Mark Questions
8. How does giving incentives for exports influence foreign exchange rate?
Explain (Delhi 2014)
Ans. The incentives for exports boosts exports for the country. As a result of
increase in exports the supply of foreign currency in the country increases. With
demand remaining the same, this results in a fall in the exchange rate implying
currency appreciation.

9. Recently Government of India has doubled the import duty on gold. What
impact is it likely to have on foreign exchange rate and how? (Delhi 2014)
Ans.When government increase the import duty of gold, the import of gold will fall.
This reduces the demand for foreign currency. With the supply of foreign currency
remaining same, the foreign exchange rate would fall.
This implies appreciation of rupees.

10. Visits of foreign countries for sightseeing etc. by the people of India is on
the rise. What will be its likely impact on foreign exchange rate and how?
(Delhi 2014)
Ans. When there is a rise in the visit of foreign countries by the people in India, the
demand for foreign currency increases. With the supply of foreign currency
remaining same, the foreign exchange rises, implying a depreciation of rupee.

11. Foreign exchange rate in India is on the rise recently. What impact is it
likely to have on exports and how? (All India 2014)
Ans. With the rise in foreign exchange rate in India, the demand for foreign currency
increases. This rise in exchange rate implies depreciation in domestic currency. It
encourages exports from a country.

12. When foreign exchange rate in a country is on the rise, what impact is it
likely to have on imports and how? (All India 2014)
Ans. With the rise in foreign exchange rate in India, the demand for foreign currency
increases. This rise in exchange rate implies depreciation in domestic currency. It
encourages exports from a country and discourages imports from rest of the world.

13. What is ‘appreciation’ of domestic currency? What is its likely effects an

exports and how? (Foreign 2014)
or
Explain the effect of appreciation of domestic currency on imports. (Delhi
2013)
Ans. Domestic currency appreciates when there is a fall in foreign exchange rate,
the domestic economy can now buy more quantity of goods and services from
foreign countries with the same amount of domestic currency. As a result imports
rise.
e.g. When Rs. / $ exchange rate falls from 55 to 50, it leads to currency appreciation
and this will help in buying more and more units of foreign goods as a result demand
for foreign goods will rise. i.e. imports will rise.

14.Explain the effect of depreciation of domestic currency on exports. (All

India 2013)
Ans. Domestic currency depreciates when there is a rise in foreign exchange rate.
Depreciation has an expansionary effect on Aggregate Demand and output.
Depreciation increases the demand for domestically produced goods by reducing
their relative price. This will lead to increase in exports and hence fall in imports, as
now foreign country can buy greater units in the domestic country with same amount
of their currency.
15. How is exchange rate determined in the foreign exchange market? (All
India 2013)
Ans. Foreign exchange rate is determined by the market forces of demand and
supply in foreign exchange market. The point where demand and supply of foreign
exchange meet, gives the equilibrium rate of exchange as shown in figure and
quantity of foreign exchange.

16. How can Reserve Bank of India help in bringing down the foreign exchange
rate which is very high? (All India 2013)
Ans. Central Bank starts selling foreign exchange from its reserve to bring down the
foreign exchange rate, as the demand for foreign exchange is very high.

17. How can increase in foreiqn direct investment affect the price of foreign
exchange? (Delhi 2013)
Ans. Increase in foreign direct investment will result in more supply of foreign
exchange therefore, due to excess supply, price of foreign exchange will fall. i.e.
exchange rate falls which leads to appreciation of domestic currency.

18. When price of a foreign currency rises, its demand falls. Explain why?
(Delhi 2011)
or
Explain, why there is a fall in demand of foreign exchange, when its price
rises. (All India 2011)
or
There is an inverse relationship between foreign exchange rate and demand
for foreign exchange. Explain why? (Delhi 2009c)
Ans. Exchange rate of foreign currency is inversely related to the demand. When
price of a foreign currency rises, it results into costlier imports for the country. As
imports become costlier, the demand for foreign products also reduce. This leads to
reduction in demand for that foreign currency and vice-versa.
19. When price of a foreign currency rises, its supply also rises. Explain
why? (Delhi 2011)
or
There is a direct relationship between price of foreign exchange and supply of
foreign exchange. Explain why?(All India 2009; Delhi 2008)
or
When the rate of a foreign currency rises, its supply iises. How?(Delhi 2008)
Ans. Rise in exchange rate of foreign currency refers to appreciation of foreign
currency in relation to domestic currency. When there is rise in foreign exchange rate
(Say from Rs. 55 per$ to Rs. 60 per $), it leads to depreciation of domestic currency
and rise in exports leading to rise in supply of foreign exchange supply.

20. When the price of a foreign currency falls, the demand for that foreign
currency rises. Explain why? (All India 2011)
or
Explain why there is a rise in demand for foreign exchange, when its price
falls? (All India 2011)
or
When the rate of exchange of foreign currency falls, its demand rises. Explain
how? (All India 2008)
Ans. Foreign exchange rate shares an inverse relationship with the demand for that
currency, with a fall in the price of foreign exchange, value of domestic currency
increases (i.e. appreciation of domestic currency) and that means foreign goods
become cheaper and their domestic demand (i.e. imports) increases. The rising
domestic demand for foreign goods implies higher demand for foreign exchange
which increased from OC1 to OQ2 as shown in the figure

21. When the price of a foreign currency falls, the supply of that foreign
currency also falls. Explain why? (All India 2011,2008)
Ans. The supply of foreign currency is directly proportional to the price of foreign
exchange. When the price of a foreign currency falls, it leads to cheaper imports and
costlier exports as it leads to appre ciation of domestic currency. The exporters are
discouraged due to costlier exports. This results lesser inflow or supply of foreign
currency in the economy. As a result supply of foreign exchange decreases from
OQ2 to OQ1

22. Give the meaning of foreign exchange rate. How it is determined under
flexible exchange rate system? (All India 2011)
Ans. Foreign exchange rate Foreign exchange rate refers to the rate at which one
currency can be exchanged for the other currency in foreign exchange market, e.g. if
Rs. 58 is paid to buy one US dollar, then Rs./$ exchange rate will be 58 i.e. Rs.58
per dollar.
Flexible rate of exchange is also called free rate of exchange, as it is freely
determined by the market forces of supply and demand of foreign exchange in the
international market. If the demand for foreign exchange rises, its value will also rise
and if demand for foreign exchange falls, its value will also fall.

Similarly, supply of foreign exchange also influences the exchange rate. Greater the
supply, lower the rate of exchange. The point at which demand for foreign exchange
and supply of foreign exchange meets, gives the equilibrium rate of exchange at OR.
Any rate above equilibrium would lead to excess supply and any exchange rate
below equilibrium would lead to excess demand.

23. Giving two examples, explain the relation between the rise in price of a
foreign currency and its demand. (Delhi 2011)
Ans. (i) when the price of a foreign currency rises, the imports become costlier and
exports become cheaper so the value of imports will fall with time, hence the
demand for foreign exchange will fall.
(ii) When domestic companies want to buy foreign assets and with the rise in price of
foreign currency the price of the assets also increases. Hence, the demand for
foreign exchange falls.
24. Distinguish between devaluation and depreciation of domestic currency.
(Delhi 2010)
Difference between devaluation and depreciation

Basis Devaluation Depreciation

Devaluation is the fall in the value of

domestic currency in relation to foreign It occurs when the value of domestic

currency. It is planned by the Central Bank currency decreases in relation to the

Meaning
in situation, when exchange rate is not of foreign currency in the foreign exc

determined by the forces of demand and market.

supply.

If US $ exchanges ? 45 instead of ?

A government has set 10 units of its earlier the domestic currency (Indian
Example
currency is equal to one dollar. rupee) has shown depreciation of do

currency.

25. Giving two examples, explain why there is a rise in demand for a foreign
currency when its price falls? (All India 2010)
Ans. (i) when there is a fall in the price of foreign currency, the import gets cheaper.
It encourages the importers to import more and consequently, the demand for that
foreign currency increases.
(ii) When the price of a foreign currency falls, the price of foreign assets also falls. It
encourages domestic people and companies to buy foreign assets and
consequently, the demand for that foreign currency increases.

26. Distinguish between fixed and flexible foreign exchange rate. (All India
2010)
Ans. Fixed exchange rate is the system, under which the central authority or
government maintains their exchange rate fixed either against gold or some other
foreign currency. Whereas the rate of exchange which is determined by the market
forces of demand and supply of foreign currencies in the foreign exchange market, is
termed as flexible exchange rate.
27. Give meanings of fixed, flexible and managed floating exchange rates.
(All India 2010; Delhi 2010)
Ans. Fixed and flexible exchange rate
(i) Minimise exchange rate fluctuations
(ii) Reduces volatility and fluctuations in prices
(iii)Imposes discipline on the monetary authority
(iv) Encourages international trade and investment flows
(v) Less speculation in the currency market
The rate of exchange which is determined by the market forces of demand and
supply of foreign currencies in the foreign exchange market, is termed as flexible
exchange rate system.
Managed floating exchange rate The system of adjusting the exchange rates as
per the rules and regulations of foreign exchange market is termed as managed
floating.

28. What is meant by appreciation and depreciation of domestic currency?

Explain. (All India 2010)
Ans. When the value of domestic currency increases in relation to a foreign currency
due to demand and supply forces in a free market, it is termed as appreciation of the
domestic currency.
Depreciation of the domestic currency occurs when the value of domestic country’s
currency decreases in relation to the foreign currency.
For example, Increase in exchange rate is currency depreciation and decrease in
exchange rate is currency appreciation.
(i) When Rs./$ exchange rate falls from 55 to 50 , it is termed as appreciation of
domestic currency (i.e. Indian rupee) –
(ii) When Rs./$ exchange rate rises from 50 to 55, it is termed as depreciation of
domestic currency .

29. Explain the meaning and two merits of fixed foreign exchange rate. (Delhi
2010,2009)
Ans.Fixed foreign exchange rate
(i) Minimise exchange rate fluctuations
(ii) Reduces volatility and fluctuations in prices
(iii)Imposes discipline on the monetary authority
(iv) Encourages international trade and investment flows
(v) Less speculation in the currency market
Two merits of fixed foreign exchange rate are:
(i) Less speculation in the currency market.
(ii) Encourages international trade and investment flows.

30. State two sources each of demand and supply of foreign exchange.
Ans. Two sources of demand for foreign exchange are:
(i) Imports from rest of the world.
(ii) Foreign investment across the world.
Two sources of supply of foreign currency are:
(i) Exports of goods and services from domestic country to foreign country .
(ii) Remittances from abroad.
4 Mark Questions
31. Explain two merits each of fixed exchange rate and flexible exchange
rate. (Delhi 2009; All India 2009)
Ans. Merits of fixed exchange rate are as follows:
(i) Minimises exchange rate fluctuations.
(ii) Encourages international trade and investment flows.
Merits of flexible exchange rate are as follows:
(i) Independent monetary policy.
(ii) No need to maintain huge stock of gold or other currency.

32. How is foreign exchange rate is determined in the market?(All India 2009)
Foreign exchange rate is determined by the market forces of demand and supply in
foreign exchange market. The point where demand and supply of foreign exchange
meet, gives the equilibrium rate of exchange

In the above figure, D stands for the demand for

foreign exchange and 5 curve represents the supply of foreign exchange for different
values of R i.e. rate of exchange. Point E is the equilibrium point, where D =5, so R
will be the rate of exchange. If the rate of exchange is arbitrarily fixed other than R,
there wi 11 be a situation of either excess demand or excess supply of foreign
exchange, so R is the rate of exchange which is obtained from the equilibrium point
E. Any disequilibrium will be adjusted automatically by the forces of demand and
supply of foreign exchange to attain equilibrium.
6 Mark Question

33. Give the meaning of foreign exchange and foreign exchange rate. Giving
reason, explain the relation between foreign exchange rate and demand for
foreign exchange. (All India 2012)

Ans. Foreign exchange Foreign exchange rate is determined by the market forces
of demand and supply in foreign exchange market. The point where demand and
supply of foreign exchange meet, gives the equilibrium rate of exchange as shown in
figure and quantity of foreign exchange.

Foreign exchange rate Foreign exchange rate refers to the rate at which one
currency can be exchanged for the other currency in foreign exchange market, e.g. if
Rs. 58 is paid to buy one US dollar, then Rs./$ exchange rate will be 58 i.e. Rs.58
per dollar.
Relation between foreign exchange rate and demand for foreign
exchange There is an inverse relationship between the foreign exchange rate and
demand for foreign exchange, with the rise in foreign exchange rate, demand for
foreign exchange falls and vice-versa.

In the above figure, D curve represent the demand for foreign currency. When
exchange rate is high (R1), demand for the foreign currency falls (Q1,). On the other
hand, when exchange rate is low (R2), demand for the foreign currency rises Q2. The
demand curve for the foreign currency is always downward sloped and signifies an
inverse relationship between demand and exchange rate i.e. price of foreign
exchange.

Question 1. How is exchange rate determined under a flexible exchange rate

regime?
Or
How is foreign exchange rate determined? Explain with diagram.
Or How is exchange rate determined in a foreign exchange market? Explain.

Answer:
1. Exchange rate in a free exchange market is determined at a point, where demand for
foreign exchange is equal to the supply of foreign exchange.
2. Let us assume that there are two countries – India and U.S.A – and the exchange rate
of their currencies i.e., rupee and dollar is to be determined.Presently, there is floating or
flexible exchange regime in both India and U.S.A. Therefore, the value of currency of
each country in terms of the other currency depends upon the demand for and supply of
their currencies.
3. In the above diagram, the price on the vertical axis is stated in terms of domestic
currency (that is, how many rupees for one US dollar). The horizontal axis measures the
quantity demanded or supplied.
4. In the above diagram, the demand curve [D$] is downward sloping. This means that
less foreign exchange is demanded as the exchange rate increases. This is due to the
fact that the rise in price of foreign exchange increases the rupee cost of foreign goods,
which make them more expensive. As a result, imports decline. Thus, the demand for
foreign exchange also decreases.The supply curve [S$] is upward sloping which means
that supply of foreign exchange increases as the exchange rate increases. This makes
home country’s goods become cheaper to foreigners since rupee is depreciating in
value. The demand for our exports should therefore increase as the exchange rate
increases. The increased demand for our exports translates into greater supply of
foreign exchange. Thus, the supply of foreign exchange increases as the exchange rate
increases.

5. The intersection of the supply and demand curves determine equilibrium exchange
rate (OP$) and equilibrium quantity [OQ$] of foreign currency i.e., US [$].

Question 2. Differentiate between devaluation and depreciation.

Answer:

Question 3. Are the concepts of demand for domestic goods and domestic
demand for goods the same?

Answer:
1. Demand for domestic goods and domestic demand for goods are two different
concepts.
2. Demand for domestic goods is a demand for goods made by both domestic and
foreign countries.
3. Domestic demand for goods is a demand for goods by our own country for
goods ..which may be produced in foreign countries.

Question 4. Would the central bank need to intervene in a managed floating

system? Explain why?

Answer:
1. In a managed floating system a central bank of a country has freedom to bring change
in the exchange rate within certain limits.
2. A country is allowed after information to the IMF to bring a certain limited amount of
change in the rate of exchange.
3. A central bank cannot bring change in its exchange rate by more than 10%. For it,
permission of IMF is necessary

I. Very Short Answer Type Questions

Question 1. What is foreign exchange?

Answer: Foreign exchange refers to all the currencies of the rest of the world other than
the domestic currency of the country. For example, in India, US dollar is foreign
exchange.

Question 2. What is meant by foreign exchange rate?

Answer: The rate at which one currency is exchanged for another is called foreign
exchange rate.

Question 3. What is meant by foreign exchange market?

Answer: Foreign exchange market is the market where foreign currencies are bought
and sold.
Question 4. Define flexible exchange rate system.

Answer: Flexible exchange rate system refers to a system in which the exchange rate of
different currencies is determined by the forces of demand and supply in foreign
exchange market.

Question 5. The price of 1 US Dollar has fallen from Rs. 50 to Rs. 48. Has the
Indian currency appreciated or depreciated?

Answer: Indian currency has appreciated.

ll. Short Answer Type Questions

Question 1. State four sources of demand of foreign exchange.

Give three reasons why people desire to have foreign exchange.
Or
What are the sources of demand for foreign exchange?

Answer: The demand (or outflow) of foreign exchange comes from the people who need
it to make payments in foreign currencies. It is demanded by the domestic residents for
the following reasons:
1. Imports of Goods and Services: When India import goods and services, foreign
exchange is demanded to make the payment for imports of goods and services.
2. Tourism: Foreign exchange is demanded to meet expenditure incurred in foreign
tours.
3. Unilateral Transfers sent abroad: Foreign exchange is required for making
unilateral transfers like sending gifts to other countries.
4. Purchase of assets in foreign countries: It is demanded to make payment for
purchase of assets, like land, shares, bonds, etc. in foreign countries.

Question 2. What are the functions of a foreign exchange market?

Answer:
1. Transfer Function: Transfer function refers to transferring of purchasing power among
countries.
2. Credit Function: It implies provision of credit in terms of foreign exchange for the
export and import of goods and services across different countries of the world.
3. Hedging Function: Hedging function pertains to protecting against foreign exchange
risks. Where Hedging is an activity which is designed to minimize the risk of loss.

Question 3. Why does demand for foreign exchange rise when its price falls?
Or What are the reasons for ‘Rise in Demand’ for Foreign Currency?

Answer: The demand for foreign currency rises in the following situations:
1. When price of a foreign currency falls, imports from that, foreign, country become
cheaper. So, imports increase and hence, the demand for foreign currency rises For
example, if price of 1 US dollar falls from Rs 60 to T 55, then imports from The USA will
increase as American goods will become relatively cheaper. It will raise the demand for
US dollar.
2. When a foreign currency becomes cheaper in terms of the domestic currency, it
promotes tourism to that country. As a result, demand for foreign currency rises.
3. When price of a foreign currency falls, its demand rises as more people want to make
gains from speculative activities.

Question 4. When price of a foreign currency rises, its demand falls’. Explain
why?
Or
Explain relation between foreign exchange rate and demand for it.
Or Why demand curve of foreign exchange is downward sloping?

Answer:
1. Demand curve of foreign exchange slopes downwards due to inverse relationship
between demand for foreign exchange and foreign exchange rate.
2. In figure, demand for foreign exchange (US dollar) and rate of foreign exchange are
shown on the horizontal axis and vertical axis respectively.
3. The demand curve [US$] is downward sloping. It means that less foreign exchange is
demanded as the exchange rate increases.
4. This is due to the fact that rise in the price of foreign exchange increases the rupee
cost of foreign goods, which make them more expensive. As a result, imports decline.
Thus, the demand for foreign exchange also decreases.

Question 5. State four sources of supply of foreign exchange. Or

What are the sources for supply of foreign exchange?

Answer: The supply (inflow) of foreign exchange comes from the people who receive it
due to the following reasons.
1. Exports of goods and services: Supply of foreign exchange comes through exports
of goods and services.
2. Foreign investment: The amount, which foreigners invest in their home country,
increases the supply of foreign exchange.
3. Remittances (unilateral transfers) from abroad: Supply of foreign exchange
increases in the form of gifts and other remittances from abroad.
4. Speculation: Supply of foreign exchange comes from those who want to speculate
on the value of foreign exchange.

Question 6. What are the reasons of ‘rise in supply’ of foreign currency?

Or
Why does a rise in foreign exchange rate cause a rise in foreign exchange
supply?
Or
When exchange rate of a foreign currency rises, its supply also rises. How?
Explain.

Answer: The supply of foreign currency rises in the following situations:

1. When price of a foreign currency rises, domestic goods become relatively cheaper. It
induces the foreign country to increase their imports from the domestic country. As a
result, supply of foreign currency rises. For example, if price of 1 US dollar rises from Rs
60 to Rs 65, then exports to USA will increase as Indian goods will become relatively
cheaper. It will raise the supply of US dollars.
2. When price of a foreign currency rises,foreign direct investment (FDI) from rest of the
world increases, which will increase the supply for foreign exchange.
3. When price of a foreign currency rises, also supply of foreign currency rises as people
want to make gains from speculative activities.
Question 7. Why supply curve of foreign exchange is upward sloping?

Answer:
1. Supply curve of foreign exchange slopes upwards due to positive relationship
between supply for foreign exchange and foreign exchange rate, which means that
supply of foreign exchange increases as the exchange rate increases.
2. This makes home country’s goods become cheaper to foreigners since rupee is
depreciating in value. The demand for our exports should therefore increase as the
exchange rate increases.
3. The increased demand for our exports will translate into greater supply of foreign
exchange. Thus, the supply of foreign exchange increases as the exchange rate
increases.

Question 8. Explain the effect of depreciation of domestic currency on exports.

Answer: Depreciation of domestic currency means a fall in the price of domestic

currency (say, rupee) in terms of a foreign currency (say, $). It means, with the same
amount of dollars, more goods can be purchased from India, i.e., exports to USA will
increase as they will become relatively cheaper.

Question 9. Explain the effect of appreciation of domestic currency on imports.

Answer: Appreciation of domestic currency means a rise in the price of domestic

currency (say, rupee) in terms of a foreign currency (say, $). Now, one rupee can be
exchanged for more $, i.e., with the same amount of money, more goods can be
purchased from the USA. It leads to increase in imports from the USA as American
goods will become relatively cheaper.
Question 10. What are the merits of fixed exchange rate system?

Answer:
1. Stability: It ensures stability, in the international money market/ exchange market. Day
to day fluctuations are avoided. It helps formulation of long term economic policies,
particularly relating to exports and imports.
2. Encourages international trade: Fixed exchange rate system implies low risk and low
uncertainty of future payments. It encourages international trade.
3. Co-ordination of macro policies:Fixed exchange rate helps co¬ordination of macro
policies across different countries of the world. Long term economic policies can be
drawn in the area of international trade and bilateral trade agreements.

Question 11. What are merits of flexible exchange rate system?

Answer:
1. No need for international reserves: Flexible exchange rate system is not to be
supported with international reserves.
2. International capital movements: Flexible exchange rate system enhances
movement of capital across different countries of the world. This is due to the fact that
member countries are no longer required to keep huge international reserves.
3. Venture capital: Flexible exchange rate promotes venture capital in foreign exchange
market. Trading in international currencies itself becomes an important economic
activity.

Question 12. Differentiate between fixed exchange rate and flexible exchange
rate?
Answer:

Question 13. Explain the meaning of Managed Floating Exchange Rate?

Answer:
1. Managed floating exchange rate is a mixture of a flexible exchange rate (the float part)
and a fixed exchange rate (the Managed part).
2. In other words, it refers to a system in which foreign exchange is determined by free
market forces (demand and supply forces), which can be influenced by the invention of
the central bank in foreign exchange market.
3. Under this system, also called Dirty floating, central banks intervene to buy or sell
foreign currencies in an attempt to stabilise exchange rate movements in case of
extreme appreciation or depreciation.

lll. True Or False

Question 1. An increase in demand for imported goods raises the supply for
foreign exchange.
Answer: False. Supply of foreign exchange will decrease in order to make the payment
for imported goods.

Question 2. Depreciation of Indian rupees will occur when Rs. 55 have to be paid
to exchange one US $ instead of present rate of Rs. 50/$.

Answer: True. In case of depreciation, more rupees have to be paid to exchange one US
dollar, i.e., greater than Rs. 50/$.

Question 3. Appreciation of domestic currency leads to rise in imports.

Answer: True. Appreciation of domestic currency makes foreign goods relatively

cheaper, which leads to increase in imports.

Question 4. Revaluation and appreciation of currency are one and the same thing.

Answer: False. Revaluation refers to increase in the value of domestic currency by the
government under fixed exchange rate. On the other hand, currency appreciation refers
to increase in the value of domestic currency in terms of foreign currency under flexible
exchange rate system.

Question 5. In spot market sale and purchase of foreign currency is settled on a

specified future date.

Answer: False. In spot market sale and purchase of foreign currency is settled
immediately.

1. Gold standard provided domestic price stability and automatic adjustment in

balance of payments and in exchange rate. Discuss.

2. Mention the features of the fixed parity system of exchange rate. What were

the causes behind its collapse ?

3. Do you agree that fixed exchange rate is better than floating rates ? Explain.

4. What do you mean by SDRs? How do they help improve international

liquidity ?

5. What are the different facilities through which the member countries get

balance of payments support from the IMF ?

6. Do you agree that the low-income countries do not get desired funds from the

IMF ? Present your arguments.