CBSE Class 12 Economics Foreign Exchange Rate and Balance of Payments Worksheet

Question. The balance of trade shows a surplus of 10000 Crore and the import of merchandise is half of the export of merchandise. Find the value of export.
(i) 20000
(ii) 10000
(iii) 5000
(iv) 1000

Answer: B

Question. Statement I: Unilateral transfers made by way of gifts, grants and remittances are treated as current transfers.
Statement II: Expenditure by tourists is included in balance of trade.
(i) Both statements are incorrect
(ii) Both statements are correct
(iii) Statement I is correct and statement II is incorrect
(iv) Statement I is Incorrect and statement II is correct

Answer: D

Question. Foreign exchange transactions which are independent of other transactions in the balance of payments account are called. Choose the correct alternative)
(a) Current transactions
(b) Capital transactions
(c) Autonomous transactions
(d) Accommodating transactions

Answer: C

Short Answer type Questions

Question. (i) In which sub-account and on which side of Balance of Payments Account will foreign investments in India be recorded ? Give reasons.
(ii) What will be the effect of foreign investments in India on exchange rate? Explain.
Answer: (i) Foreign investments will be recorded in the Capital Account of the BOP Account because these give rise to foreign exchange liabilities. Foreign investment will be recorded on the credit side because these bring in foreign exchange to the economy.
(ii) Foreign investment adds to supply of foreign exchange. Demand remaining unchanged, it brings downward influence on exchange rate.

Question. Indian investors borrow from abroad. Answer the following
(i) In which sub-account and on which side of the Balance of Payments Account will this borrowing be recorded ? Give reason.
(ii) Explain what is the impact of this borrowing on exchange rate.
Answer: (i) Borrowings from abroad are recorded in the Capital Account of the BOP because these give rise to foreign exchange liabilities. These are recorded on the credit side because these bring foreign exchange into the country.
(ii) Borrowing from abroad raise supply of foreign exchange. Demand for foreign exchange remaining unchanged, exchange rate is likely to fall.

Question. What is meant by ‘Official Reserve Transactions’? Discuss their importance in Balance of Payments.
Answer: Transactions by a Central Bank that cause changes in its official reserves. These are usually purchases or sales of its own currency in the exchange market in exchange for foreign currencies or other foreign-currency-denominated assets. 2 They may be Autonomous Receipts and Autonomous Payments, disequilibrium between which may occur as deficit/surplus in Balance of payments.

Question. Are the following entered
(a) On the credit side or debit side and
(b) In the Current Account or Capital Account in the Balance of Payments Account?
You must give reason for your answer.
(i) Investment from Abroad.
(ii) Transfer of funds to relatives abroad.
Answer: (a) (i) Investment from abroad-It is entered to credit side.
(ii) Transfer of Funds to relatives abroad: It is entered to debit side.
(b) (i) Investment from abroad-Capital Account because Capital Account records capital transfers between one country and rest of the world.

Question. In the context of Balance of Payments Account, state whether the following statements are true or false. Give reasons for your answer.
(i) Profits received from investments abroad is recorded in Capital Account.
(ii) Import of machines is recorded in Current Account.
Answer: (i) False, it is recorded in current account as it neither affects foreign exchange assets nor foreign exchange liabilities.
Ii True, all imports and exports of goods are recorded in trade account which is a part of current account, because it is simply import/export of a good.

Question. State whether the following statements are true or false. Give reasons for your answer:
(i) Difference between value of exports and imports of goods and services is called Trade Balance.
(ii) External assistance is not recorded in Balance of Payments Account.
Answer: (i) False. Difference between the value of exports and imports of goods and services is called Balance of Payment not Balance of Trade.
(ii) False. It is a part of Balance of Payments or external assistance is recorded in Balance of Payments Account.

Question. Giving reasons state whether the following:-
(i) Excess of foreign exchange receipts over foreign exchange payments on account of accommodating transactions equals deficit in Balance of Payments.
(ii) Export and Import of machines are recorded in Capital Account of the Balance of Payments Account.
Answer: (i) False. As Accommodating Transactions remove both surplus and deficit of Balance of Payments Account.
(ii) False. As export and import of machines are recorded in Current Account of Balance of Payments Account.

Question. Giving reasons state whether the following statements are true or false:
(i) Current Account of Balance of Payments Account records only exports and imports of goods and services.
(ii) Foreign investments are recorded in Capital Account of Balance of Payments.
Answer: (i) False. As Current Account of Balance of Payments Account also records unilateral transfers. (ii) True. As all kind of foreign investments (Foreign Direct Investments and Port Folio Investments) are included in the Capital Account of Balance of Payments.

Question. What is ‘appreciation’ of domestic currency? What is its likely effects an exports and how?
                                           or
Explain the effect of appreciation of domestic currency on imports.
Answer: 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.

Question. Explain the effect of depreciation of domestic currency on exports.
Answer: 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.

Question. How can increase in foreign direct investment affect the price of foreign exchange?
Answer: 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.

Question. Do you think that a surplus in capital account BoP reflects prosperity of the nation?
Answer: No, it is incorrect to say because surplus in capital account balance of payments may have been achieved through loan which are a financial obligation to rest of the world.

Question. Explain the Different Concepts of Foreign Exchange Rate
Answer: (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.

Question. How would you argue for and against foreign investment?
Answer: Arguments against foreign investment:
Leads to rise in claims by foreigners against assets in the domestic economy.
Arguments in favors of foreign investment:
Overall investment in the domestic economy is expanded.

Question. Distinguish between trade account and current account of balance of payments account.
Answer: In trade account import and export of goods are recorded.
In current account import and export of goods and services are recorded. Factor income and transfer payment are also recorded.

Question. State the effect of the following on the balance of payments situation.
(i) Increase in import duty of gold.
(ii) Rise in the price of foreign currency.
Answer: (i) This will reduce import of gold and thus will have a favorable effect on BOP situation, as demand for foreign exchange will fall.
(ii) Rise in price of foreign currency will make imports costlier, so import will fall and it will be favorable for BOP, as demand for foreign exchange will fall.

Question. What will be the effect of the following on the balance of payments ?
(i) ‘Make in India’ programmed.
(ii) import of pulses.
Answer: (i) ‘Make in India’ will increase supply (inflow) of foreign exchange in India causing improvement in the balance of payments position.
(ii) Import of pulses will lead to outflow of foreign exchange from the country causing adverse effect on balance of payment position.

Foreign Exchange Rate
 

Short Answer type Questions
 

Question. What is Foreign Exchange?
Answer: Foreign exchange refers to any currency other than the domestic currency of a specific country. It encompasses foreign banknotes, coins, bank deposits, and various financial instruments denominated in a foreign currency.
In simple words: Foreign exchange is any foreign currency that a country uses to buy goods and services from other nations.

Exam Tip: Do not just define it as "foreign currency" - mention that it includes bank balances and bills of exchange denominated in foreign currencies as well.

Question. What is Foreign Exchange Rate?
Answer: The foreign exchange rate is the price of one national currency expressed in terms of another currency. It indicates how many units of the domestic currency are required to purchase a single unit of a foreign currency.
In simple words: The exchange rate is like a price tag that shows how much of your own money you need to buy another country's money.

Exam Tip: Providing a small example, such as \( \$1 = \text{Rs. } 83 \), helps demonstrate a clear and practical understanding of the definition.

Question. What is meant by Foreign exchange market?
Answer: The foreign exchange market is a global, decentralized network where various national currencies are traded, bought, and sold. It is not limited to a single physical location and comprises commercial banks, central banks, brokers, and individual traders.
In simple words: It is a worldwide network where people, banks, and governments trade different national currencies with each other.

Exam Tip: Clarify that the foreign exchange market is a virtual network operating continuously across multiple time zones, rather than a physical marketplace.

Question. What is the role played by Foreign exchange market?
Answer: The foreign exchange market performs three crucial functions:
1. Transfer Function: Facilitating the transfer of purchasing power from one country to another.
2. Credit Function: Providing credit and short-term financing for international trade.
3. Hedging Function: Allowing businesses to lock in exchange rates for future transactions to protect themselves from currency price fluctuations.
In simple words: This market helps move money between countries, offers credit for trade, and protects businesses from sudden changes in currency values.

Exam Tip: Memorize the three key terms - Transfer, Credit, and Hedging - to structure your answer effectively for full marks.

Question. What are spot markets in foreign exchange?
Answer: The spot market is the segment of the foreign exchange market where transactions are settled immediately or "on the spot." The exchange rate used is the spot rate, and delivery of the currency usually occurs within two business days.
In simple words: The spot market is where currencies are bought and sold for immediate delivery and quick payment.

Exam Tip: Clearly mention the "immediate" nature of transactions and the typical two-day settlement period to secure full points.

Question. What are forward markets in foreign exchange?
Answer: The forward market is the segment of the foreign exchange market where contracts are signed today to buy or sell a currency at a specified future date at a rate agreed upon today. This agreed price is called the forward exchange rate.
In simple words: This is a market where traders lock in a price today to trade currency at some point in the future to avoid risk.

Exam Tip: Highlight that the main purpose of the forward market is "hedging" - protecting traders from unexpected future changes in exchange rates.

Question. What is NEER?
Answer: NEER stands for Nominal Effective Exchange Rate. It is a weighted average of bilateral exchange rates of the domestic currency against a select basket of foreign currencies, without adjusting for price inflation.
In simple words: NEER is a single number that shows the average value of a country's currency compared to a group of major foreign currencies.

Exam Tip: Do not forget to mention that NEER is "unadjusted for inflation" - this is the key difference between NEER and REER.

Question. What is REER?
Answer: REER stands for Real Effective Exchange Rate. It represents the weighted average of a country's currency relative to an index of major foreign currencies, adjusted for the differences in price inflation levels between the countries.
In simple words: REER is the NEER adjusted for inflation, which shows how competitive a country's goods are in the global market.

Exam Tip: Remember that REER is a crucial economic indicator used to assess a country's international trade competitiveness.

Question. What is RER?
Answer: RER stands for Real Exchange Rate. It measures the relative price of goods and services between two countries. It is calculated by multiplying the nominal exchange rate by the ratio of foreign price levels to domestic price levels: \[ \text{RER} = e \times \left( \frac{P_f}{P} \right) \] where \( e \) is the nominal exchange rate, \( P_f \) is the foreign price level, and \( P \) is the domestic price level.
In simple words: The real exchange rate tells you how many foreign goods you can buy with the same amount of money compared to domestic goods.

Exam Tip: Writing down the mathematical formula alongside the definition demonstrates excellent conceptual clarity and earns full marks.

Question. Name two ways of expressing the foreign exchange rate.
Answer: The two ways of expressing the foreign exchange rate are:
1. Direct Quote: Stating the number of units of domestic currency needed to buy one unit of foreign currency (e.g., \( \$1 = \text{Rs. } 83 \)).
2. Indirect Quote: Stating the amount of foreign currency that can be purchased with one unit of domestic currency (e.g., \( \text{Re. } 1 = \$0.012 \)).
In simple words: You can show how much local money is needed to buy one foreign coin, or how much foreign money you get for one local coin.

Exam Tip: Provide a quick, clear numerical example for both types of quotes to make your explanation concrete.

Question. Ten US dollars are exchanged for five hundred Indian rupees. What is the exchange rate of Indian currency?
Answer: Given that \( \$10 = \text{Rs. } 500 \), we can calculate the exchange rate of the Indian currency (the value of one Rupee in terms of Dollars) as: \[ \text{Re. } 1 = \frac{\$10}{500} = \$0.02 \] This means that the exchange rate for one Indian Rupee is 0.02 US Dollars.
In simple words: To find the value of a single Rupee, we divide 10 dollars by 500 rupees, which gives 0.02 dollars per rupee.

Exam Tip: Read the question carefully to see whose currency rate is asked. Since it asks for "the exchange rate of Indian currency," you must solve for 1 Rupee, not 1 Dollar.

Question. If $9 are needed to buy £2, what is the exchange rate for US dollar?
Answer: Given that \( \$9 = £2 \), the exchange rate for one US Dollar (expressed in British Pounds) is: \[ \$1 = \frac{£2}{9} \approx £0.22 \] This indicates that the exchange rate of one US Dollar is approximately 0.22 British Pounds.
In simple words: Divide 2 pounds by 9 dollars to find that one dollar is worth about 0.22 pounds.

Exam Tip: Show the step-by-step division clearly and round the final decimal value to two or three decimal places.

Question. What is meant by appreciation/depreciation?
Answer: Under a flexible exchange rate system:
- Currency Appreciation: This refers to an increase in the value of the domestic currency in terms of a foreign currency. Fewer units of domestic currency are needed to buy one unit of foreign currency (e.g., from \( \$1 = \text{Rs. } 80 \) to \( \$1 = \text{Rs. } 75 \)).
- Currency Depreciation: This refers to a decrease in the value of the domestic currency in terms of a foreign currency. More units of domestic currency are required to buy one unit of foreign currency (e.g., from \( \$1 = \text{Rs. } 80 \) to \( \$1 = \text{Rs. } 85 \)).
In simple words: Appreciation means your money becomes stronger and buys more foreign currency. Depreciation means your money becomes weaker and buys less.

Exam Tip: Make sure to highlight that appreciation and depreciation are driven by market forces of demand and supply in a floating system, with no government interference.

Question. What does a change from $3= £1 to $2=£1 represent?
Answer: A change in the rate from \( \$3 = £1 \) to \( \$2 = £1 \) represents:
1. Appreciation of the US Dollar (USD), because fewer dollars are now required to purchase one British Pound.
2. Depreciation of the British Pound (GBP), because one pound can now buy fewer US dollars than before.
In simple words: It means the US dollar has become stronger (appreciated) because you need fewer dollars to buy a pound, while the pound has become weaker (depreciated).

Exam Tip: When explaining exchange rate changes, always mention the impact on both currencies to make your answer complete.

Question. What does a change from $3= £1 to $5=£1 represent?
Answer: A shift from \( \$3 = £1 \) to \( \$5 = £1 \) represents:
1. Depreciation of the US Dollar (USD), as more dollars are now needed to buy one British Pound.
2. Appreciation of the British Pound (GBP), since a single pound can now purchase more US dollars.
In simple words: This means the US dollar has become weaker (depreciated) because you need more of them to buy a pound, while the pound has gotten stronger (appreciated).

Exam Tip: Remember that if one currency in a pair depreciates, the opposing currency must appreciate. Keep this inverse relationship in mind.

Question. Why people desire to have foreign exchange?
Answer: Individuals and organizations require foreign exchange for several major reasons:
1. Imports: To purchase foreign goods, machinery, and services.
2. Foreign Travel: To cover tourism, dining, and stay expenses while traveling abroad.
3. Unilateral Transfers: To send cash gifts or financial aid to family members residing in other nations.
4. Investment: To acquire financial assets, businesses, or real estate in foreign countries.
5. Speculation: To buy foreign currencies hoping to sell them at a profit when rates change.
In simple words: People need foreign money to buy imported goods, travel, send money to relatives abroad, make foreign investments, or trade for profit.

Exam Tip: Listing at least four clear points using brief bullet points will help you secure maximum marks for this direct descriptive question.

Question. Why does the demand for foreign exchange rise when its price falls?
Answer: When the price of foreign exchange falls, foreign products and services become cheaper for domestic consumers. This increases imports, requiring more foreign currency to pay for them. Furthermore, foreign tourism and asset purchases become more affordable, which further increases the total demand for foreign exchange.
In simple words: When foreign currency gets cheaper, foreign products and travel become less expensive. We buy more from them, which means we need more of their money.

Exam Tip: Connect the price drop directly to the rise in imports - this is the key microeconomic reasoning behind the downward-sloping demand curve.

Question. Why is the demand curve for foreign exchange negatively sloped?
Answer: The demand curve for foreign exchange is negatively sloped because of the inverse relationship between the exchange rate and the quantity demanded of foreign currency. As the exchange rate increases, foreign goods become more expensive for domestic buyers, reducing demand. Conversely, as the exchange rate decreases, foreign goods become cheaper, boosting demand.
In simple words: The demand curve slopes downward because when foreign currency becomes expensive, people want less of it, and when it is cheap, they want more.

Exam Tip: Drawing a simple diagram showing a downward-sloping demand curve with 'Exchange Rate' on the vertical axis and 'Demand' on the horizontal axis is highly recommended.

Question. Why does a rise in foreign exchange cause a rise in its supply?
Answer: A rise in the price of foreign exchange (depreciation of domestic currency) makes domestic goods cheaper and more attractive to foreign buyers. This leads to an increase in domestic exports. To purchase these exports, foreign buyers must supply more of their foreign currency. Additionally, domestic assets become less expensive, encouraging more foreign investment inflow.
In simple words: When foreign currency goes up in value, our goods look cheaper to foreigners. They buy more from us, which brings more of their money into our economy.

Exam Tip: Base your explanation on the rise in exports and the increase in foreign investments to provide a comprehensive answer.

Question. Why is the supply curve of foreign exchange positively sloped?
Answer: The supply curve of foreign exchange is positively sloped because there is a direct relationship between the exchange rate and the quantity supplied of foreign currency. A higher exchange rate makes domestic goods and services cheaper for foreign buyers, leading to higher exports and a larger inflow of foreign exchange.
In simple words: It slopes upward because a stronger foreign currency encourages foreigners to buy more of our goods, which increases the supply of foreign money in our market.

Exam Tip: Clearly state that the positive slope is due to the "direct relationship" between the exchange rate and supply, driven mainly by exports.

Question. How is Foreign Exchange rate determined?
Answer: In a flexible or floating exchange rate system, the foreign exchange rate is determined by the interaction of the market forces of demand and supply. The equilibrium rate of exchange is established at the exact point where the demand curve for foreign exchange intersects the supply curve of foreign exchange.
In simple words: The exchange rate is decided by how much foreign currency people want (demand) compared to how much is available (supply) in the free market.

Exam Tip: A simple demand and supply intersection diagram with an equilibrium point 'E' is the best way to earn full marks for this question.

Question. What is meant by fixed exchange rate?
Answer: A fixed exchange rate is an exchange rate system where the value of a nation's currency is set and maintained at a specific level by the government or central bank against another major currency (like the US Dollar) or a basket of currencies.
In simple words: This is when the government decides exactly how much its currency is worth compared to other currencies and keeps it locked at that price.

Exam Tip: Clarify that the government or central bank must actively buy and sell currencies in the market to maintain this pegged rate.

Question. What are the advantages of fixed exchange rate system?
Answer: The primary advantages of a fixed exchange rate system are:
1. Stability: It ensures stability in exchange rates, making international trade and investment predictable and secure.
2. Prevents Speculation: It eliminates uncertainty and discourages speculative activities in the foreign exchange market.
3. Policy Discipline: It forces governments to manage domestic inflation and maintain sensible fiscal policies to defend the peg.
In simple words: It makes international trade safer because prices do not change suddenly, and it stops people from speculating on currency values.

Exam Tip: Focus on terms like "stability in international trade" and "reduction of speculative risks" as the core benefits of this system.

Question. What is meant by flexible exchange rate?
Answer: A flexible exchange rate system (also known as a floating exchange rate) is a system where the exchange rate is determined entirely by the market forces of demand and supply of foreign currency, without any direct intervention from the government or central bank.
In simple words: It is a system where currency values go up and down naturally based on trade, like the prices of normal goods.

Exam Tip: Use the term "market-determined exchange rate" to describe this system clearly in your answers.

Question. What are the advantages of flexible foreign exchange system?
Answer: The main advantages of a flexible exchange rate system include:
1. Automatic Adjustment: It automatically corrects disequilibrium in the balance of payments through natural rate movements.
2. No Reserve Requirements: The central bank does not need to maintain huge foreign currency reserves to support a fixed rate.
3. Monetary Autonomy: The government can design and execute independent monetary policies focused on domestic goals like growth and employment.
In simple words: The exchange rate adjusts itself naturally, the country does not need to store massive foreign currency reserves, and the government has more freedom to manage the domestic economy.

Exam Tip: Highlight "automatic correction of BoP" and "monetary policy independence" as key advantages of this system.

Question. What are the sources of supply of foreign exchange ?
Answer: The primary sources of supply of foreign exchange include:
1. Exports: Foreigners purchasing domestic goods and services must pay in foreign currency.
2. Foreign Investments: Inflows of foreign direct investment (FDI) and portfolio investments.
3. Remittances: Money sent home by citizens working abroad.
4. Tourism: Spending by international tourists visiting the country.
5. Speculation: Foreigners purchasing the domestic currency expecting its value to rise.
In simple words: Foreign money comes into a country from selling exports, foreign investments, tourism, and money sent home by citizens working abroad.

Exam Tip: Presenting this answer as a numbered list with headings for each point makes it clean and highly readable for the examiner.

Question. What is parity value?
Answer: Parity value (or par value) is the officially determined value of a currency expressed in terms of gold or another major currency (like the US dollar) under a fixed exchange rate system.
In simple words: Parity value is the official price set for a currency, usually tied to gold or a strong foreign currency.

Exam Tip: Associate this term directly with fixed exchange rate regimes, particularly the Gold Standard or the Bretton Woods system.

Question. What is meant by Crawling peg?
Answer: A crawling peg is an exchange rate system where a currency is pegged to another currency, but the pegged rate is adjusted frequently by small margins in response to economic indicators like inflation rates.
In simple words: It is a system where the government keeps the exchange rate fixed, but slowly adjusts it by tiny steps to keep up with economic changes.

Exam Tip: Explain it as a hybrid system that combines features of both fixed and flexible exchange rate systems.

Question. What is meant by Managed float?
Answer: A managed float system (often called "dirty floating") is a system where the exchange rate is primarily determined by market forces of demand and supply, but the central bank occasionally intervenes to buy or sell foreign currency to prevent excessive fluctuations.
In simple words: The exchange rate floats freely, but the central bank steps in to buy or sell currency if the price starts changing too wildly.

Exam Tip: Emphasize that the central bank's intervention is intended to "smooth out volatility" rather than stick to a fixed exchange rate.

Question. What can be the effect of instability in the exchange rate?
Answer: Instability in the exchange rate can have several unfavorable consequences:
1. Harms Trade: Rapid fluctuations create uncertainty, making exporters and importers hesitant to enter contracts.
2. Discourages Foreign Investment: Foreign investors avoid countries with unstable currencies due to the risk of currency losses.
3. Inflation: Sharp depreciation can lead to "imported inflation" by making essential imported goods like oil more expensive.
4. Speculative Attacks: Large variations can lead to panic selling of the domestic currency.
In simple words: Unstable exchange rates make trade risky, scare away foreign investors, can cause domestic prices to rise, and create panic in financial markets.

Exam Tip: Use terms like "exchange rate risk" and "imported inflation" to show a strong understanding of macroeconomic concepts.

Question. What can give rise to worst currency crises?
Answer: The most severe currency crises are typically caused by a combination of:
1. Chronic BoP Deficits: Persistent deficits funded by short-term foreign loans.
2. Excessive External Debt: High amounts of foreign-currency debt that the country cannot service.
3. Speculative Attacks: Global traders selling off massive amounts of the currency in expectation of devaluation.
4. Capital Flight: A sudden, rapid exit of foreign investment due to economic policy failure or political turmoil.
In simple words: A currency crisis happens when a country borrows too much foreign money, runs out of reserves, and investors panic and pull their money out of the country.

Exam Tip: You can cite a real-world example, such as the 1997 Asian Financial Crisis, to demonstrate how these factors combine to trigger a crisis.