Foreign Exchange Rate NCERT SOLUTION CLASS 12TH MACRO ECONOMICS | EDUGROWN NOTES

TEXTBOOK QUESTIONS AND ANSWER:

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Q.1 How is exchange rate determined under a flexible exchange rate regime? [6 Marks]
Or
How is foreign exchange rate determined? Explain with diagram.
Or [AI 2004; CBSE 06 q How is exchange rate determined in a foreign exchange market? Explain.[AI 2013 (Set 1)]
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 [$].

Q.2 Differentiate between devaluation and depreciation. [3 Marks]
ANSWER:

Q.3 Are the concepts of demand for domestic goods and domestic demand for goods the same? [3 Marks]
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.

Q.4 Would the central bank need tointervene in a managed floating system? Explain why? [3 Marks]
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.

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MORE QUESTIONS SOLVED

Very Short Answer Type Questions :

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Q.1 What is foreign exchange?[CBSE AI 2011, 04]
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.

Q.2 What is meant by foreign exchange rate? [CBSE 2004,05,06,09 2011, Sample Paper 2010]
ANSWER:   The rate at which one currency is exchanged for another is called foreign exchange rate.

Q.3 What is meant by foreign exchange market?
ANSWER:  Foreign exchange market is the market where foreign currencies are bought and sold.

Q.4 Define flexible exchange rate system.[CBSE 2008]
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.

Q.5The price of 1 US Dollar has fallen from Rs. 50 to Rs. 48. Has the Indian currency appreciated or depreciated?[CBSE Sample Paper 2010]
ANSWER:  Indian currency has appreciated.

Short Answer Type Questions :

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Q.1 State four sources of demand of foreign exchange.[CBSE 2004, 05, 05C, 07; A 05, 10] Or
Give three reasons why people desire to have foreign exchange.
Or [CBSE 2005]
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.

Q.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.

Q.3 Why does demand for foreign exchange rise when its price falls?
Or [AI 2006, 08, 10] 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.

Q.4 When price of a foreign currency rises, its demand falls’. Explain why?
Or [CBSE 2011]
Explain relation between foreign exchange rate and demand for it.
Or [CBSE 2004q 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.

Q.5 State four sources of supply of foreign exchange.[CBSE 2004, 05, 05C, 07, 10; AI 05] 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.

Q.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? [CBSE 2006, 08]
Or
When exchange rate of a foreign currency rises, its supply also rises. How? Explain. [CBSE 2008]
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.

Q.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.

Q.8 Explain the effect of depreciation of domestic currency on exports.
[A7 2013 (Set I), Sample Paper 2013]
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.

Q.9 Explain the effect of appreciation of domestic currency on imports.
[CBSE 2013 (Set I), Sample Paper 2013)]
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.

Q.10 What are the merits of fixed exchange rate system? [CBSE 2009]
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.

Q.11What are merits of flexible exchange rate system? [CBSE, AI 2009]
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.

Q.12 Differentiate between fixed exchange rate and flexible exchange rate? [AI 2015]
ANSWER:

Q.13 Explain the meaning of Managed Floating Exchange Rate? [AI 2015]
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.

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