Continuation of part A- foreign exchange

Question 1.
State four sources each of demand and supply of foreign exchange. (C.B.S.E 2010)
Answer:
Following are the four sources each of demand for and supply of the foreign exchange:

Sources of Demand for Foreign Exchange

 Purchase of goods and services from other countries

 Send gift abroad
 Purchase of financial assets in a particular country
 Speculative trading on the value of the foreign currencies

Sources of Supply of Foreign Exchange

 Foreigners purchasing home country’s goods and services through exports

 Foreign investment in home country through joint ventures
 Foreign investment in heme country through the financial market operations
 Foreign currencies flow into the economy through the currency dealers and
speculators

Question 2.
How is foreign exchange rate determined? Use diagram. (C.B.S.E. Outside Delhi 2013)
Or
Discuss briefly the concept of flexible exchange rate system of foreign exchange rate
determination. (C.B.S.E. Outside Delhi 2019)
Answer:
The exchange: rate in the foreign market is determined:by the intersection; of supply
and demand, curves of the foreign exchange .The foreign exchange market, like any
other normal market, comprises of a downward sloping demand curve and an upward
sloping supply curve.
In the following diagram, the vertical shows

He states in terms of the domestic currency, Cruf is,” amount of rupee for one US
dollar, The horizontal axis measures the quantity demanded or supped. At point E, the
intersection of demand and supply curves determines the equilibrium exchange rate in
the foreign market (R*) and equilibrium quantity (Q*) of the foreign currency, that is, US
dollar ($).

An increase in the demand for US dollars in India will cause the demand curve to shift to
D’$ and the exchange rate rises to R’. Similarly, an increase in the supply of US dollars
will cause the supply curve shift to S’$ and the exchange rate falls to RT In this: case,
the domestic currency is more valuable.

Question3.
Explain the impact of rise in exchange rate on national income. (C.8.S.E 2018)
Answer:
A rise in the foreign exchange rate implies that the price of foreign currency, in terms of
domestic currency, has increased. Since domestic goods and services have become
cheaper, the foreign country can now buy higher quantity from one unit of its currency.

This will result in increased demand for Indian exports. Moreover, depreciation of
domestic currency will make the imports from foreign countries more expensive. Thus,
there will be increase in exports and fall in imports, causing the net exports to rise.
Consequently, the net aggregate demand for domestically produced goods will increase
and so will the national income.

Question 4.
When exchange rate of foreign currency rises, its supply rises. How? Explain. (C.B.S.E
2011)
Answer:
The foreign exchange rate is the price of one currency in terms of another currency. A
rise in the foreign exchange rate implies that the price of foreign currency, in terms of
domestic currency, has increased. Since domestic goods and services have become
cheaper, the foreign country can now buy higher quantity from one unit of its currency.
This increases the supply of foreign currency in the domestic country.

For instance, suppose the foreign exchange rate between India and UK has increased.
The price of one pound has increased from ₹ 60 to ₹ 70. It implies that UK citizens can
buy ₹ 70 worth of goods by parting one pound compared to only ₹ 60 worth of goods
prior to rise in exchange rate. Since Indian goods have become cheaper for UK, they
will buy more of them. This increases the supply of UK pounds to India. Thus, a rise in
foreign exchange rate causes a rise in its supply.

Question 5.
When exchange rate of foreign currency fells its demand rises. Explain how? (CBS.E.
Outside Delhi 2011)
Answer:
The foreign exchange rate is the price of one currency in terms of another currency. A
fall in the foreign exchange rate implies that the price of foreign currency, in terms of
domestic currency, has l decreased. Since foreign goods and services have become
cheaper, the domestic country can now buy higher quantity.

This increases the demand for foreign currency in the domestic country. : For instance,
suppose the foreign exchange rate between India and UK has decreased. The price of
one pound has fallen from ₹ 70 to ₹ 60. It implies that Indians have to pay only ₹ 60 to
buy one pound worth: of goods compared to ₹ 70 prior to fell in exchange rate. Since
goods in UK have become cheaper for; India, Indians will buy more of them. This
increases the demand for UK pounds in India Thus, a fall in foreign exchange rate
causes a rise in its demand :

Question 6.
Give two reasons for a rise in demand for a foreign currency when its price fells.
Answer:
Following are the two reasons for the rise in the demand for a foreign currency when its
price falls:
(i) When the price of a foreign currency falls, the imports from that country become
cheaper. As a result, imports increase, and hence, the demand for the foreign currency
also rises.

(ii) When a foreign currency becomes cheaper in terms of domestic currency, people
plan investment in foreign country. As a result, demand for that foreign currency rises.

Question 7.
State any two merits and demerits of flexible exchange rate system:
Answer:
Merits of Flexible Exchange Rate System
(i) Flexible exchange rate system automatically corrects the deficit or surplus in the
Balance of Payments account.
(ii) The government is not required to hold any foreign exchange reserves.

Demerits of Flexible Exchange Rate System

(i) It encourages speculation in the foreign exchange market.
(ii) There can be wide fluctuations in exchange rate, which may cause instability in the
foreign trade.

Question 8.
Explain two merits each of fixed foreign exchange rate.
Answer:
Merits of Fixed Exchange Rate System
(i) Fixed exchange rate system ensures stability in foreign exchange market.
(ii) It prevents speculative activities in foreign exchange market.

Question 9.
There is an inverse relation between foreign exchange rate and demand for foreign
exchange.Why? Explain.
Answer:
There is an inverse relationship between demand for foreign exchange and rate of
exchange.

The curve showing demand for the foreign exchange (DD) slopes downward from left to
right. This implies that higher the exchange rate, lower would be the demand for foreign
exchange, and vice-versa. The diagram shows that when the exchange rate is OR then
the demand for foreign exchange is OQ. However, when the exchange rate declines to
OR’, then the demand for foreign exchange increases to OQ’.
Question 10.
Explain the meaning of managed flexible exchange rate.
Or
Discuss briefly the concept of managed floating system of foreign exchange rate
determination. (C.B.S.E Outside Delhi 2019)
Answer:
Managed flexible foreign exchange rate is a system, which allows adjustments in
exchange rate according to a set of rules and regulations officially declared in the
foreign exchange market. There is no pre-defined range and time for the adjustment.
Adjustment is allowed entirely on the merits of a care. It is for the managing authority to
allow or reject the appeal for adjustment.

Question 11.
When price of a foreign currency rises, its demand falls. Explain why? (C.B.S.E Comp.
2011,2012)
Answer:
The foreign exchange rate is the price of one currency in terms of another currency. A
rise in the foreign exchange rate implies that the price of foreign currency, in terms of
domestic currency, has increased. Since foreign goods and services have become
expensive, the domestic country can now buy less of them.

This decreases the demand for foreign currency in the domestic country. For instance,
suppose the foreign exchange rate between India and UK has increased. The price of
one pound has increased from ₹ 70 to ₹ 80. It implies that Indians have to pay ₹ 80 to
buy one pound worth of goods compared to ₹ 70 prior to rise in exchange rate.

Since goods in UK have become expensive for India, Indians will buy less of them. This
decreases the demand for UK pounds in India. Thus, a rise in foreign exchange rate
causes a fall in its demand.

Question 12.
When price of a foreign currency falls, the supply of that foreign currency also falls.
Explain why? (C.B.S.E Outside Delhi 2011)
Answer:
The foreign exchange rate is the price of one currency in terms of another currency. A
fall in the foreign exchange rate implies that the price of foreign currency, in terms of
domestic currency, has decreased. Since domestic goods and services have become
expensive, the foreign country can now buy lesser quantity from one unit of its currency.
This decreases the supply of foreign currency in the domestic country.

For instance, suppose the foreign exchange rate between India and UK has decreased.
The price of one pound has decreased from ₹ 60 to ₹ 50. It implies that UK citizens can
buy only ₹ 50 worth of goods by parting one pound compared to only ₹ 60 worth of
goods prior to fall in exchange rate. Since Indian goods have become expensive for UK
citizens, they will buy less of them. This decreases the supply of UK pounds to India.
Thus, a fall in foreign exchange rate causes a fall in its supply.

Question 13.
Explain the effect of appreciation of domestic currency on imports. (C.B.S.E 2013)
Answer:
Appreciation of a currency means an increase in the value of the domestic currency in
terms of the foreign currency. The price of the domestic currency, in terms of a foreign
currency, increases and the foreign exchange rate decreases. For instance, suppose
rupee has appreciated in terms of pound.

That is, the foreign exchange rate between India and UK has decreased. The price of
one pound has decreased from ₹ 70 to ₹ 60. It implies that Indian citizens can buy one
pound worth of goods by parting only ₹ 60 compared to ₹ 70 priorto fall in exchange
rate. Since UK goods have become cheaper for Indians, they will buy more of them.
Consequently, Indian imports from UK will increase.

Question 14.
Explain the effect of depreciation of domestic currency on exports. (C.B.S.E Outside
Delhi 2013)
Answer:
Depreciation of a currency means a decrease in the value of the domestic currency in
terms of the foreign currency. The price of the domestic currency, in terms of a foreign
currency, decreases and the foreign exchange rate increases. For instance, suppose
rupee has depreciated in terms of pound.

That is, the foreign exchange rate between India and UK has increased. The price of
one pound has increased from ₹ 60 to ₹ 70. It implies that UK citizens can buy ₹ 70
worth of goods by parting one pound compared to only ₹ 60 worth of goods prior to rise
in exchange rate. Since Indian goods have become cheaper for UK, they will buy more
of them. Consequently, Indian exports to UK will increase.

Question 15.
Recently Government of India has doubled the import duty on gold.What impact is it
likely to have on foreign exchange rate and how? (C.B.S.E 2014)
Answer:
When the import duty on gold rises, the import of gold would become costlier. This
would reduce
the demand for foreign currency. Since the supply of foreign currency remains the
same, the foreign exchange rate would fall. This implies appreciation of rupees.
In the diagram, point E determines the equilibrium exchange rate in the foreign market
(R*) and equilibrium quantity (Q*) of the foreign currency, where demand (DD) and
supply (SS) curves intersect. A fall in the demand for foreign currency will cause the
demand curve to shift-to the left from DD to D1D1, and the exchange rate falls to R1 New
equilibrium is established at E1.

Question 16.
Distinguish between appreciation of home currency and depreciation of home currency.
(C.B.S.E Outside Delhi 2019)
Answer:
Appreciation of home currency means increase in the value of the domestic currency in
terms of the currencies of the other countries. On the other hand, depreciation of home
currency means lowering of the value of the domestic currency in terms of the
currencies of the other countries.

Question 17.
Explain the effect of appreciation of domestic currency on exports. (C.B.S.E Outside
Delhi 2014)
Answer:
Appreciation of a currency means an increase in the value of the domestic currency in
terms of the foreign currency. The price of the domestic currency, in terms of a foreign
currency, increases and the foreign exchange rate decreases. For instance, suppose
rupee has appreciated in terms of pound.

That is, the foreign exchange rate between India and UK has decreased. The price of
one pound has decreased from ₹ 70 to ₹ 60. UK citizens can buy only 60 worth of
goods by parting one pound compared to X 70 worth of goods prior to fall in exchange
rate. Since Indian goods have become expensive for UK citizens, they will buy less of
them. Consequently, Indian exports to UK will decrease.
Question 18.
How does giving incentives for exports influence foreign exchange rate? Explain.
(C.B.S.E 2014)
Answer:
The incentives for exports boost exports of the country. An increase in exports causes
the supply of foreign currency to increase in the domestic country while the demand
remains unchanged. Consequently, the exchange rate falls and the domestic currency
appreciates. in the diagram, point E determines the equilibrium exchange rate in the
foreign market (R*) and equilibrium quantity (0*) of the foreign currency, where demand
(DD) and supply (SS) curves intersect. A rise in the supply for foreign currency will
cause the supply curve to shift to the right from SS to S1 S1 and the exchange rate falls
to R1.

Question 19.
Vista to foreign countries for sight seeing etc by the people of India in the rise. What will
be its impact on foreign exchange rate? How?
Answer:
Increase in the foreign visits of Indian residents would increase the demand for foreign
currency increases. Since the supply of foreign currency remains the same, the foreign
exchange rate would rise implying depreciation of rupee.
In the diagram, point E determines the equilibrium exchange rate in the foreign market
(R*) and equilibrium quantity (Q*) of the foreign currency, where demand (DD) and
supply (SS) curves intersect. A rise in the demand for foreign currency will cause the
demand curve to shift to the right from DD to D1D1 and the exchange rate rises to R1.

Question 20
What is foreign exchange rate? Explain how it is determined.
Answer:
Foreign exchange rate is the price of one unit of the foreign currency in terms of the
domestic currency.
Determination of Foreign Exchange Rate: Foreign Exchange Rate is determined in the
exchange
market at the point of intersection of foreign exchange demand and supply curves.

1. Demand Curve of Foreign Exchange: A country is dependent upon other countries for
its requirements of imports and foreign capital. Demand for foreign exchange arises to
make payments for these imports. There is an inverse relationship between the demand
for foreign exchange and the rate of exchange. If the exchange rate increases, the
demand for foreign exchange would fall and the vice-versa.

In the diagram, demand for foreign exchange is OD when exchange rate is OR. When
the rate of exchange falls to OR, then demand for foreign exchange increases to OD,.
Demand curve for foreign exchange (DD) curve slopes downwards from left to right.

2. Supply Curve of Foreign Exchange: Supply of foreign exchange depends on a

number of factors like the value of exports of a country, import of capital, extent of
foreign investment, etc. There is direct relation between exchange rate and the supply
of foreign exchange. An increase in the exchange rate results in an increase in the
supply of foreign exchange and vice-versa.

In the diagram, the supply of foreign exchange is OS when exchange rate is equal to
OR. If the exchange rate is increased to OR,, supply of capital also increases to OS,.
SS is the positively sloped supply curve of foreign exchange.
3. Equilibrium Foreign Exchange Rate: Equilibrium exchange rate is determined at a
level where demand for foreign exchange is equal to supply of foreign exchange. The
determination of equilibrium foreign exchange rate can be explained with the help of
given diagram:

The demand for foreign exchange is equal to supply of foreign exchange at point E. the
equilibrium foreign exchange rate is OR and equilibrium quantity of foreign exchange is
OQ. MN represents excess demand for foreign exchange at OR,. Similarly, KL
represents excess supply of foreign exchange at OR2.

for foreign exchange decreases to OQ’.

Question 21.
Why does the demand for foreign currency fall and supply rises when its price rises ?
Explain. (C.B.S.E. 2017)
Answer:
When the price of the foreign currency increases, the value of domestic currency
increases in terms of the foreign currency. In other words, we can say that the domestic
currency depreciates.

Now in such a case, there are two implications.

(a) Since the domestic currency has depreciated the imports become expensive. The
domestic traders will have to pay more to buy the same units of foreign good. This leads
to a decline in the demand for the foreign currency.

(b) At the same time, with a depreciation in the domestic currency, the exports become
cheaper. This will bring in more foreign currency hence, leading to an increase in the
foreign exchange supply.
Question 22
Why is flexible rate of exchange called free rate of exchange?
Answer:
Flexible rate of exchange is called free rate of exchange as it is freely determined by the
forces of supply and demand in the international money market.