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Questions:

Multiple Choice Question

5 x 1 = 5

Unilateral transfers are a part of:

(a)

Capital Account

(b)

Current Account

(c)

Balance of Trade Account

(d)

Balance of Payment Account and Current Account

Other things remaining the same, when foreign currency becomes cheaper, them effect on national income is likely to be : (Choose the correct alternative).

(a)

Positive

(b)

Negative

(c)

Positive and negative both

(d)

No effect

Which items are excluded in BOT, but included in BoP?

(a)

Visible items

(b)

Invisible items

(c)

Private capital

(d)

Both (b) and (c)

Balance of payments deficit is calculated by taking into account the ............... only.

(a)

accommodating transactions

(b)

autonomous transactions

(c)

unilateral transactions

(d)

None of the above

............... is a situation when 'managed floating' is exercised by the central bank.

(a)

crawling peg

(b)

Spot market

(c)

Dirty Floating

(d)

None of these

Generic 4

7 x 4 = 28

How is the exchange rate determined under a flexible exchange rate regime?

Explain why there is an inverse relationship between price of foreign currency and its demand.

Explain the effect of appreciation of domestic currency (or a fall in the price of foreign currency) on imports and exports.

Distinguish between current account and capital account of balance of payments accounts. Is import of machinery recorded in the capital account. Give reasons for your answer.

10.

State the components of capital account of Balance of payments.

11.

When the price of foreign currency rises, its supply also rises. Explain why?

12.

How does giving incentives for exports influence foreign exchange rate? Explain.

Generic 3

1 x 3 = 3

13.

Balance of Trade shows a deficit of RS.5000 crore. Value of exports is RS.4000 crore. Find out the value of imports.

Fill up / 1 Marks

10 x 1 = 10

14.

Name two sources of supply of foreign exchange.

15.

The price of 1 US Dollar has fallen from Rs 50 to Rs 45. Has the Indian currency appreciated or depreciated ?

16.

What is meant by depreciation of domestic currency?

17.

State two sources of demand for foreign exchange.

18.

What does a change from $£$1= 3 to $£$1 = $ 2 represent ?

19.

Define devaluation of domestic currency.

20.

What is foreign exchange

21.

Define capital account of BoP.

22.

What does a deficit in balance of trade account indicate ?

23.

What is 'trade balance'?

Generic 6

1 x 6 = 6

24.

Give, the meaning of foreign exchange and foreign exchange rate. Giving reasons, explain the relation between foreign exchange rate and demand for foreign exchange.

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Answers Key:

Multiple Choice Question

5 x 1 = 5

(d)
Balance of Payment Account and Current Account

(b)
Negative

Both (b) and (c)

autonomous transactions

Dirty Floating

Generic 4

7 x 4 = 28

Under a flexible exchange rate regime (also called the floating exchange rate regime), the exchange rate is determined by the interaction of the market forces of demand and supply of foreign exchange in the international money market. In this exchange rate system, the central bank does not intervene in the foreign exchange market
Now explaining this exchange rate determination with the help of a diagram. We denote, the amount of foreign exchange demanded and supplied on the OX axis and the exchange rate on the OY axis $DD'$ in the diagram shows the downward sloping demand curve for foreign exchange (FE) and SSdenotes the upward sloping supply curve of FE. Point 'X' denotes the point of Foreign exchange determination or point of equilibrium.
$\therefore DD'$ intersects $SS'$ at this point
i.e., $D_{ E.E }=S_{ F.E }$
Oe, denotes the equilibrium exchange rate and OM denotes the equilibrium amount of F.E.

There is an inverse relation between foreign exchange rate and demand for foreign exchange. Higher the foreign exchange rate, the lower the demand for foreign exchange and lower the foreign exchange rate, higher the demand for foreign exchange. At a lower price of US dollar, India is ready to buy more goods from USA. This raises the demand for US dollars. So, lower the price of US dollars, higher is the demand for US dollars and vice versa. Graphically, the demand curve of foreign exchange is downward sloping signifying the inverse relation between foreign exchange rate and demand for foreign exchange In the figure, at price OP, the demand for foreign exchange is OF. At a lower price $OP_{ 0 }$ the demand is $OF_{ 1 }$ i.e., higher. At a higher price $OP_{ 1 }$ demand for foreign exchange is $OF_{ 0 }$ i.e., lower

Analysing the effect of fall in the price of foreign currency (appreciation of domestic currency) upon imports and exports: we notice that the imports will now, becom cheaper and exports costlier. So, appreciation leads to more imports and less exports.

1.The current account of balance of payments includes both balance of trade accounts and the invisible account. It is thus the sum of visible balance and invisibles balance on current account whereas the capital account of balance of payment indicates all the inflows and outflows of capital. Those flows of capital may be in the form of borrowings from and lending to abroad, both by the private and government etc.
2.Balance on Current account = Sum of credits on current account-sum of debits on current capital account whereas
3.Balance on capital account Sum of credits on capital account - Sum of debits on capital account Since, import of machinery is import of a good, so it is recorded in the current account, which deals with the import and export of goods and services.

10.

The components of capital account of Balance of payments are as follows:(i)
(i) Foreign investment It includes Foreign Direct Investment and foreign institutional or portfolio investment by the residents of the country in abroad or by the rest of the world in domestic country.
(ii) Borrowings It includes commercial borrowing by the government or private sector from the rest of the world and external assistance to/by a country.
(iii) Official international reserve It includes the changes in gold and foreign exchange reserve with the Central Bank.

11.

Rise in exchange rate of a foreign currency refers to appreciation of foreign currency in relation to domestic currency.

It causes a rise in supply of foreign currency owning to the following situations:

(i) It includes greater Foreign Direct Investment (FDI).

(ii) Appreciation of foreign currency includes greater exports from the domestic economy

(iii) Appreciation of foreign currency includes direct purchase by the non-residents in the domestic economy.

12.

The incentives for exports boost 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.

Generic 3

1 x 3 = 3

13.

Balance of Trade=Value of Exports- Value of Imports

-RS500=RS400-Value of Imports

$\therefore $ Value of Imports=RS.9000 crore

Fill up / 1 Marks

10 x 1 = 10

14.

()
Supply of foreign exchange is from
(i) Exports of goods and services. (ii) Transfer payments in form of cash remittances, donation etc.

15.

()
When the price of 1 US $ falls from Rs 50 to Rs 45, Indian currency (Rs) appreciates and is more valuable.

16.

()
When the price of foreign currency in term of domestic currency rises in the foreign exchange market, it is known as 'depreciation' of domestic currency.

17.

()
Demand for foreign exchange (i) for importing goods and services (ii) for making investment abroad in financial and physical assets.

18.

()
It represents an appreciation of Dollar ($)

19.

()
The deliberate raising of the price of foreign currency in terms of domestic currency, by the government is called 'devaluation of domestic currency.

20.

()
Foreign exchange refers to all the currencies other than the domestic currency of a given country.

21.

()
Capital Account of BoP, records the sources and uses of foreign exchange, on account of transactions representing changes in foreign financial assets and foreign financial liabilities.

22.

()
When the value of import of goods of a country is greater than the value of export of goods, it leads to a deficit in the BOT.

23.

()
BOT, also called 'trade balance' is the difference between the value of export of goods and import of goods.

Generic 6

1 x 6 = 6

24.

Foreign exchange refers to any foreign currency. Thus, US dollars, British pounds are foreign exchange for India. Foreign exchange rate is the price of one currency in terms of another currency. It is the rate at which exports and imports of a country are valued during a period of time.
There is an inverse relation between foreign exchange rate and demand for foreign exchange. Higher the foreign exchange rate, lower the demand for foreign exchange and lower the foreign exchange, rate, higher the demand
for foreign exchange. Suppose the' price of US dollar in India falls from Rs 50 to Rs 40. It means that earlier Indian people had to part with Rs 50 to buy one dollar worth of goods from USA. Now they have to part with Rs 40 to buy one dollar worth of goods from USA. It implies that American goods have become cheaper for Indian buyers. At a lower price of US dollar, India is ready to buy more goods from USA.
This raises the demand for US dollars. So, lower the price of US dollars,higher is the demand for US dollars and vice versa. Graphically, the demand curve of foreign exchange is downward sloping y signifying the inverse relation between foreign exchange rate and demand for foreign exchange. In the figure, at price Or, the demand for foreign exchange is OF. At a lower price ' the demand is $OP_{ 0 }$ , i.e., higher. At a higher price $OF_{ 1 }$ , demand is $OP_{ 1 }$ i.e., lower than OF.