Foreign Exchange Rate

Notes for Macro

Economics
Foreign Exchange And Its Related Concepts

1. 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 the foreign
exchange.
2. The rate at which one currency is exchanged for another is called Foreign Exchange
Rate.

n other words, the foreign exchange rate is the price of one currency stated in terms of
another currency. For example, if one U.S dollar exchanges for 60 Indian rupees, then
the rate of exchange is 1$ = Rs. 60 or 1 Rs = 1/60 or 0.0166 U.S. dollar.
3. Foreign exchange market is the market where the national currencies are
converted, exchanged or traded for one another.
4. Functions of a foreign exchange market
(a) Transfer Function: Transfer function refers to transferring of purchasing power
among countries.
(b) 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.
(c) 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.
5. Sources of demand of foreign exchange:
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:
(a) Imports of Goods and Services: When India imports goods and services, foreign
exchange is demanded to make the payment for imports of goods and services.

(b) Tourism: Foreign exchange is demanded to meet expenditure incurred in foreign tours.

(c) Unilateral Transfers Sent Abroad: Foreign exchange is required for making unilateral
transfers like sending gifts to other countries.
(d) Purchase of Assets in Foreign Countries: It is demanded to make payment for purchase of
assets, like land, shares, bonds, etc. in foreign countries.
(e) Repayment of loans to Foreigners: As and when we have to pay interest and repay the loans
to foreign lenders, we require foreign exchange.
(d) Speculation: Demand for foreign exchange arises when people want to make gains from
appreciation of currency.
6. Reasons for ‘Rise in Demand’ for Foreign Currency:
The demand for foreign currency rises in the following situations:
(a) 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 Rs. 55, then imports from the USA will increase as American
goods will become relatively cheaper. It will raise the demand for US dollar.

(b) 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.
(c) When price of a foreign currency falls, its demand rises as more people want to make gains
from speculative activities.
7. Demand curve of foreign exchange is downward sloping:

(a) Demand curve of foreign exchange slopes downwards due to inverse relationship between
demand for foreign exchange and foreign exchange rate.
(b) In figure, demand for foreign exchange (US dollar) and rate of foreign exchange are shown
on the horizontal axis and vertical axis respectively.

(c) The demand curve [US$] is downward sloping. It means that less foreign exchange is
demanded as the exchange rate increase
(d) 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.
8. Sources of supply of foreign exchange: The supply (inflow) of foreign exchange comes
from the people who receive it due to the following reasons.
(a) Exports of Goods and Services: Supply of foreign exchange comes through exports of goods
and services.
(b) Tourism: The amount, which foreigners spend in the home country, increases the supply of
foreign exchange.
(c) Remittances (unilateral transfers) from Abroad: Supply of foreign exchange increases in the
form of gifts and other remittances from abroad.
(d) Loan from Rest of the world: It refers to borrowing from abroad. A loan from U.S. means flow
of U.S. $ from U.S. to India, which will increase supply of Foreign exchange.

(e) Foreign Investment: The amount, which foreigners invest in our home country, increases the
supply of foreign exchange.
(f) Speculation: Supply of foreign exchange comes from those who want to speculate on the
value of foreign exchange.
9. Reasons of‘rise in supply’ of foreign currency: The supply of foreign currency rises in the
following situations:
(a) 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.
(b) 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.

(c) When price of a foreign currency rises, supply of foreign currency also rises as people want
to make gains from speculative activities.
10. Supply curve of foreign exchange is upward sloping:

(a) 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.
(b) 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.
(c) 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.
How Foreign Exchange Is Determine, Disequilibrium Conditions Under Exchange
Rate

1. Determination of foreign exchange rate:

(a) 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.
(b) 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.
(c) 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.
(d) In the above diagram, the demand curve [D$] is downward sloping. This means that
less foreign exchange is demanded as the exchange rate increases. This is due to the
fact that the rise in price of foreign exchange increases the rupee cost of foreign goods,
which make them more expensive. As a result, imports decline. Thus, the demand for
foreign exchange also decreases.
(e) The supply curve [S$] 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.
2. Disequilibrium conditions under equilibriun exchange rate:
(a)Change in demand:
(i) Increase in demand for dollar: An increase in the demand for US dollar in India will
cause the demand curve to shift to D1$ and the exchange rate rises to P1$. Note that
increase in the exchange rate means that more rupees are required to buy one US
dollar. When this occurs, Indian rupee is said to be depreciating.

(b) Change in Supply

(i) Increase in supply for dollar: An increase in the supply of US dollar causes the supply
curve to shift to S1$ and exchange rate falls to P1$. In this case, rupee cost of US dollar
is decreasing and the Indian rupee is said to be appreciating.

(ii) Decrease in demand for dollar: A decrease in the demand for US dollar in India will
cause the demand curve to shift to D1$ and the exchange rate falls to P1$. Note that
decrease in the exchange rate means that less rupees are required to buy one US
dollar. When this occurs, Indian rupee is said to be appreciating.
(ii) Decrease in supply of dollar: A decrease in the supply of US dollar causes the
supply curve to shift to S1$ and exchange rate rises to P1$. In this case, rupee cost of
US dollar is increasing and the Indian rupee is said to be depreciating.

Exchange Rate Regimes (Fixed, Flexible And Managed Floating Exchange Rate
And Their Merits And Demerits)

Types of exchange rate regimes:

1. Fixed exchange rate system (Pegged exchange rate system):
(a) Meaning:
(i) The system of exchange rate in which exchange rate is officially declared and fixed
by the government is called fixed exchange rate system.
(ii) When domestic currency is tied to the value of foreign currency, it is known as
pegging.
(iii) To maintain stability in fixed exchange rate system, government buy foreign
currency when exchange rate appreciates and sell foreign currency when exchange
rate depreciate. This process is called Pegging operation, i.e., all efforts made by the
central bank to keep the rate of exchange stable.
Note:
(i) Fixed exchange rate is not determined by the forces of demand and supply in the
market. Such a rate of exchange has been associated with Gold Standard System
during 1880-1914.
(ii) According to this system, value of every currency is determined in terms of gold.
Accordingly, ratio between gold value of the two countries was fixed as exchange rate
between those currencies.
(iii) For example, Value of one dollar = 100 gms of gold.
Value of a rupee = 5 gms of gold
Then, 1 dollar = 100/5 = Rs. 20
(b) Merits of fixed exchange rate system:
(i) Stability: It ensures stability, in the international money market/exchange market. Day
seto day fluctuations are avoided. It helps formulation of long term economic policies,
particularly relating to exports and imports.
(ii) Encourages international trade: Fixed exchange rate system implies low risk and low
uncertainty of future payments. It encourages international trade.
(iii) 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.
(c) Demerits of fixed exchange rate system:
(i) Huge international reserves: Fixed exchange rate system is often supported with
huge international reserves of gold. This is because different currencies are directly or
indirectly convertible into gold.
(ii) Restricted movement of capital: Fixed exchange rate restricts the movement
of capital across different parts of the world. Accordingly, international growth process
suffers. .v
(iii) Discourages venture capital: Venture capital in the international money market
refers to investments in the purchase of foreign exchange in the international money
market with a view to earn profits. Fixed exchange rate system discourages such
investments. Fixed exchange rate discourages venture capital in the international
money market.
(d) Devaluation of currency: Devaluation refers to decrease in the value of domestic
currency in terms of foreign currency by the government. It is a part of fixed
exchange rate.
(e) Revaluation of currency: Revaluation refers to increase in the value of domestic
currency by the central government. It is a part of fixed exchange rate.
2. Flexible exchange rate (floating exchange rate system):
(a) Meaning:
(i) The system of exchange rate in which value of a currency is allowed to float freely as
determined by demand for and supply of foreign exchange is called flexible exchange
rate system.
(ii) Under this system, the central banks, without intervention, allow the exchange rate to
adjust to equate the supply and demand for foreign currency.
(iii) The foreign exchange market is busy at all times by changes in the exchange rates.
(b) Merits of flexible exchange rate system:
(i) No need for international reserves: Flexible exchange rate system is not to be
supported with international reserves.
(ii) 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.
(iii) Venture capital: Flexible exchange rate promotes venture capital in foreign
exchange market. Trading in international currencies itself becomes an important
economic activity.
(c) Demerits of flexible exchange rate system:
(i) Instability: It causes instability in the international money market. Exchange rate
tends to fluctuate like price of goods in the commodity market.
(ii) International trade: Instability in foreign exchange market causes instability in the
area of international trade. It becomes difficult to draw long period policies of exports
and imports.
(iii) Macro policies: While fixed exchange rate helps coordination of macro policies,
flexible exchange rate makes it a difficult proposition. Day to day fluctuations in
exchange rate makes bilateral trade agreements a difficult exercise.
(d) Currency depreciation:
(i) Currency depreciation refers to decrease in the value of domestic currency in terms
of foreign currency. It makes the domestic currency less valuable and more of it is
required to buy a foreign currency. It is a part of flexible exchange rate.
(ii) For example, rupee is said to be depreciating if price of $1 rises from ? 60 to Rs. 65.
(iii) Effect of depreciation of domestic currency on exports: 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.
(e) Currency appreciation:
(i) Currency appreciation refers to increase in the value of domestic currency in terms of
foreign currency. The domestic currency becomes more valuable and less of it is
required to buy a-foreign currency. It is a part of flexible exchange rate.
(ii) For example, Indian rupee appreciates when price of $1 falls from Rs. 60 to Rs. 55.
(iii) Effect of appreciation of domestic currency on imports: 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.
3. Managed floating rate system:
(a) Managed floating exchange rate is a mixture of a flexible exchange rate (the float
part) and a fixed exchange rate (the Managed part).
(b) 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 intervention
of the central bank in foreign exchange market.
(c) Under this system, also called Dirty floating, central banks intervene to buy or sell
foreign currencies in an attempt to stabilize exchange rate movements in case of
extreme appreciation or depreciation.

Kinds Of Foreign Exchange Rate (Spot And Forward Market)

1. Spot market for foreign exchange:

(a) If the operation is of daily nature, it is called spot market or current market.
(b) The exchange rate that prevails in the spots market for foreign exchange is called
spot rate.
(c) In other words, spot rate of exchange refers to the rate at which foreign currency is
available on the spot.
2. Forward market for foreign exchange:
(a) A market for foreign exchange for future delivery is known as forward market.
(b) Exchange rate that prevails in a forward contract for purchase or sale of foreign
exchange is called forward rate.
(c) Thus, forward rate is the rate at which a future contract for foreign currency is bought
and sold.

Other Types Of Exchange Rate System

1. Wider band System:

(a) It is a system that allows wider adjustment in the fixed exchange rate system.
(b) It allows adjustment upto 10% around the “parity” between any two currencies in the
internationahmoney market.
(c) For example, if one US dollar is fixed as equal to fifty Indian rupees, 10% revision
(upward or downward) is to be allowed in this exchange rate of 1: 50. Exchange rate
may be revised as,
1: 60 + 10% = 1: 66 or as 1: 60 – 10% = 1 : 54
2. Crawling peg system:
(a) It allows “small” but regular adjustments in the exchange rate for different currencies.
(b) Not more than (+) 1% adjustment is allowed at a time. Indeed, it is a small
adjustment.
(c) But it can crawl, i.e., it can be repeated at regular intervals.

Some Important Terms

1. Nominal exchange rate (NER): The number of units of domestic currency required
to purchase a unit of foreign currency is called nominal exchange rate. Thus, $1 = Rs.
60. It may move to $1 = Rs. 65, and so on.
2. Nominal effective exchange rate (NEER):
(a) The concept is useful for an aggregative analysis. A nation has to deal with a
number of countries, and hence a number of currencies.
(b) For example, during a period Indian rupee may be losing value against the American
dollar, but it may be gaining value against Euro.
(c) Therefore, we would be interested in knowing what is happening in aggregate to our
rupee i.e., is it gaining or losing.
(d) For this purpose, we prepare a basket of all the currencies which we are interested
in, and find out the average of the changes in these currencies in a given period. This
gives us the nominal effective exchange rate (NEER).
(e) So, finally NEER is the measure of average relative strength of a given currency with
respect to other currencies without eliminating the effect of change in price.
3. Real exchange rate (RER): RER is the exchange rate which is calculated after
eliminating the effects of price change. Therefore, RER is based on constant prices.
4. Real effective exchange rate (REER): REER is the measure of average relative
strength of a given currency with respect to other currencies after eliminating the effects
of price change.
5. Parity value: In the context of exchange rate in foreign exchange market, parity
value refers to the value of one currency in terms of the other for a given basket of
goods and services. If a U.S. dollar buys 50 times the goods and services in India,
compared to a rupee, the parity value of a US dollar should be 50 : 1. Accordingly, the
exchange rate between rupee and a US dollar ought to be Rs. 50 : 1$. Any change in
the parity value would imply a corresponding change in exchange rate.

Words that Matter

1. Foreign exchange: It 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 the foreign
exchange.
2. Foreign Exchange Rate: The rate at which one currency is exchanged for another is
called Foreign Exchange Rate.
3. Foreign exchange market: It is the market where the national currencies are
converted, exchanged or traded for one another.
4. 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.
5. Fixed exchange rate system: The system of exchange rate in which exchange rate
is officially declared and fixed by the government is called fixed exchange rate system.
6. Pegging: When domestic currency is tied to the value of foreign currency, it is known
as pegging.
7. Pegging operations: It refers to all efforts made by the central government to keep
the rate of exchange stable.
8. Venture capital: Venture capital in the international money market refers to
investments in the purchase of foreign exchange in the international money market with
a view to earn profits.
9. Devaluation: It refers to decrease in the value of domestic currency in terms of
foreign currency by the government. It is a part of fixed exchange rate.
10. Revaluation: It refers to increase in the value of domestic currency by the central
government. It is a part of fixed exchange rate.
11. Flexible Exchange Rate: The system of exchange rate in which value of a currency
is allowed to float freely as determined by demand for and supply of foreign exchange is
called flexible exchange rate system.
12. Currency depreciation: It refers to decrease in the value of domestic currency in
terms of foreign currency. It makes the domestic currency less valuable and more of it is
required to buy a foreign currency. It is a part of flexible exchange rate.
13. Currency appreciation: It refers to increase in the value of domestic currency in
terms of foreign currency. The domestic currency becomes more valuable and less of it
is required to buy a foreign currency. It is a part of flexible exchange rate.
14. Managed floating exchange rate: It is a mixture of a flexible exchange rate (the
float part) and a fixed exchange rate) the Managed part).
15.Spot Rate: If the operation is of daily nature, it is called spot market or current
market.
16. Forward Rate: A market for foreign exchange for future delivery is known as
forward market.
17. Nominal Exchange Rate (NER): The number of units of domestic currency
required to purchase a unit of foreign currency is called nominal exchange rate.
18. Nominal Effective Exchange Rate (NEER): It is the measure of average relative
strength of a given currency with respect to other currencies without eliminating the
effect of change in price.
19. Real Exchange Rate (RER): It is the exchange rate which is calculated after
eliminating the effects of price change. Therefore, RER is based on constant prices.
20. Real Effective Exchange Rate (REER): It is the measure of average relative
strength of a given currency with respect to other currencies after eliminating the effects
of price changes.
21. Parity value: It refers to the value of one currency in terms of the other for a given
basket of goods and services.

Filed Under: CBSETagged With: cbse notes, Class 12 Macro Economics Notes, class 12
notes, ncert notes, Revision Notes

Chapter 6 Open Economy

Question and answer

Question 1:

Differentiate between balance of trade and current account balance.

ANSWER:

Points of Balance of trade Current account balance

difference

Definition It is the difference between the It is the difference between the values of
values of exports and imports of exports and imports of goods, services and
goods of a country. unilateral transfers of a country.

Components 1. Export of goods Export and import of goods, export and

import of services, unilateral transfers.
2. Import of goods

Nature of It records transactions related to It records the transactions related to visible

transactions visible items (i.e. goods) only. items (goods) as well as invisible items
(services) and unilateral transfers.

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Question 2:

What are official reserve transactions? Explain their importance in the balance of payments.
ANSWER:

The transactions carried by monetary authority of a country, which cause changes in official
reserves, are termed as official reserve transactions (ORT). These transactions are carried
through purchase or sale of currency in the exchange market for foreign currencies or other
assets. The reserves are drawn by selling foreign currencies in exchange market during
deficits and foreign currencies are purchased during surplus. When the official reserves
increases or decreases, it is called overall balance of payments surplus or deficit
respectively.

Importance of ORT in balance of payments:

1. Purchase of a country’s own currency is a credit item in the balance of payments;

whereas, sale of the currency is a debit item.

2. It helps to adjust the deficit and surplus in balance of payments.

 Page No 96:

Question 3:

Distinguish between the nominal exchange rate and the real exchange rate. If you were to
decide whether to buy domestic goods or foreign goods, which rate would be more
relevant? Explain.
ANSWER:

Nominal exchange rate is the price of one currency in terms of another. It is the amount of
domestic currency required to buy one unit of foreign currency. For example a rupee-dollar
exchange rate of Rs 45 means that it costs 45 rupees to buy 1 dollar.

Real exchange rate is the ratio of foreign prices to domestic prices. In other words, it
measures foreign prices relative to domestic prices.

Real exchange rate

Where Pf − price level of foreign currency

P − Price level of domestic currency

e − Nominal exchange rate

For example, if a watch costs $40 in US and the nominal exchange rate is Rs 50 per US
dollar, then, with real exchange rate of 1, it should cost Rs 2,000 (ePf = 50 × 40 = Rs 2000)
in India.

If, I were to decide whether to buy domestic goods or foreign goods, then real exchange
rate will be more relevant, because real exchange rate takes the inflation differential among
the countries into account and is also used as an indicator of a country’s competitiveness in
the foreign trade.

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Question 4:

Suppose it takes 1.25 yen to buy a rupee, and the price level in Japan is 3 and the price
level in India is 1.2. Calculate the real exchange rate between India and Japan (the price of
Japanese goods in terms of Indian goods). (Hint: First find out the nominal exchange rate
as a price of yen in rupees).
ANSWER:

Price level in foreign country: (Japan) Pf = 3

Price level in home country: (India) P = 1.2

Now, real exchange rate

Price of 1.25 yen = 1 rupee

Price of 1 yen

Therefore,

So, real exchange rate

=2

Therefore, the real exchange rate is 2.

Page No 96:

Question 5:

Explain the automatic mechanism by which BoP equilibrium was achieved under the gold
standard.
ANSWER:

Under the gold standard system, gold was taken as a common unit for measuring other
country’s currency. Thus, the value of a currency was defined in terms of gold. The
exchange rate in an open market was determined by its worth in terms of gold. It was fixed
in lower limits and upper limits, under which it was allowed to fluctuate. So, the exchange
rate became stable under gold standard. All the countries maintained stock of gold to
exchange currency.

Page No 96:

Question 6:

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

Under flexible exchange rate regime, the rate of exchange is determined by the forces of
demand and supply. In other words, the equilibrium rate of exchange occurs where demand
and supply are equal to each other. This can be illustrated with the help of the given figure:

In the figure, x−axis represents demand for and supply of foreign currency and y−axis
represents the exchange rate. DD is the demand curve that is downward slopping, showing
an inverse relationship between the rate of exchange and demand for foreign currency.
Whereas, the supply curve is upward sloping, showing positive relationship between the
rate of exchange and the supply of foreign currency. E is the equilibrium rate of exchange,
where the demand equates the supply of foreign exchange (OR). Now, if the exchange rate
rises to OR1, then the supply exceeds the demand, forcing the exchange rate to fall back to
OR. On the contrary, if the exchange rate falls to OR 2, there is excess demand over supply.
Hence, the rate of exchange rises from R2 to R. Hence, the equilibrium exchange rate (OR)
is determined by demand and supply of foreign currency.
 Page No 96:

Question 7:

Differentiate between devaluation and depreciation.

ANSWER:

Devaluation Depreciation

It occurs when the currency exchange rate is When the value of currency falls as compared
officially lowered under fixed exchange rate to other currencies, it is known as
system. depreciation.

It exists under fixed exchange rate. It exists under flexible exchange rate.

It is due to government’s decision It is due to the demand and supply forces.

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Question 8:

Would the central bank need to intervene in a managed floating system? Explain why.
ANSWER:

Managed floating system is a combination of two systems − fixed and floating exchange
rate systems. It calls for the government or central bank to intervene when the need for the
same is needed. The government or the central bank helps in moderating the exchange
rate movements by purchasing and selling of foreign currency. Thus, to avoid dirty floating,
the government exercises its power to intervene, whenever the need arises.

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Question 9:

Are the concepts of demand for domestic goods and domestic demand for goods the
same?
ANSWER:

In a closed economy, the demand for domestic goods and domestic demand for goods are
similar terms. However, in an open economy, these two terms have different meanings.
Demand for domestic goods includes both domestic and foreign demand for domestic
goods. Whereas, domestic demand for goods refers to the domestic market demand of a
country, that is either produced domestically or abroad (foreign countries).

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Question 10:

What is the marginal propensity to import when M = 60 + 0.06Y? What is the relationship
between the marginal propensity to import and the aggregate demand function?
ANSWER:

Marginal propensity to import is the fraction of additional income spent on imports.

It is given that M = 60 + 0.06Y

Therefore, marginal propensity to import (m) = 0.06. It reflects induced imports; that is the
part of the total imports, which is a function of income.

Since the marginal propensity to import negatively affects the aggregate demand function,
when income increases the aggregate demand decreases. This is because the additional
income is spent on foreign goods and not on domestic products.

Question 11:

Why is the open economy autonomous expenditure multiplier smaller than the closed
economy one?
ANSWER:

In case of a closed economy, equilibrium level of income is given by

Y = C + cY + I + G

Or, Y − cY = C + I + G

Or, Y (1 − c) = C + I + G

Or, Y=C+I+G1−c Y=C+I+G1-c

Let, (C + I + G) = A1
Or, Y=A11−c Y=A11-c
ΔYΔA1=11−c ∆Y∆A1=11-c (1)

In the case of an open economy, equilibrium level of income is given by

Y = C + cY + I + G + X − M − mY

Or, Y − cY + mY = C + I + G + X − M

Or, Y (1 − c + m) = C + I + G + X − M

Or, Y=C+I+G + X − M1− c + m Y=C+I+G + X - M1- c + m

Let autonomous expenditure (A2) = C + I + G + X − M

Or, Y = A21−c+m Y = A21-c+m

ΔYΔA2=11−c + m ∆Y∆A2=11-c + m (1)

Comparing equations (1) and (2) and the denominators of the two multipliers, we can conclude
that multiplier in an open economy is smaller than that in a closed economy, as the denominator
in an open economy is greater than denominator in a closed economy.

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Question 12:

Calculate the open economy multiplier with proportional taxes, T = tY, instead of lump−sum
taxes as assumed in the text.
ANSWER:

In the case of proportional tax, the equilibrium income would be

Y = C + c (1 − t) Y + I + G + X − M − mY

Y − c (1 − t) Y + mY = C + I +G + X − M

Y[1 − c (1 − t) +m] = C + I + G + X − M

Autonomous expenditure (A) = C + I + G + X − M

Therefore, open economy multiplier with proportional taxes

Page No 96:

Question 13:

Suppose C = 40 + 0.8Y D. T = 50, I = 60, G = 40, X = 90, M = 50 + 0.05Y

(a) Find equilibrium income

(b) Find the net export balance at equilibrium income

(c) What happens to equilibrium income and the net export balance when the government
purchases increase from 40 to 50?
ANSWER:

C = 40 + 0.8YD

T = 50

I = 60

G = 40

X = 90

M = 50 + 0.05Y

(a) Equilibrium level of income

Y = C + c (Y − T) + I + G + X − M − mY

Where, A = C − CT + I + G + X − M
= 560

(b) Net exports at equilibrium income

NX = X − M − mY

= 90 − 50 − 0.05 × 560

= 40 − 28 = 12

(c) When G increase from 40 to 50,

Equilibrium income

Net export balance at equilibrium income

NX = X − (M − mY)

= 90 − 50 + 0.05 × 600

= 40 − 30 = 10
 Page No 96:

Question 14:

In the above example, if exports change to X = 100, find the change in equilibrium income
and the net export balance.
ANSWER:

C = 40 + 0.8 YD

T = 50

I = 60

G = 40

X = 100

M = 50 + 0.05Y

Equilibrium income (Y)

Net export balance NX = X − M − 0.05Y

= 100 − 50 − 0.05 × 600

= 50 − 0.05 × 60

= 50 − 30 = 20
 Page No 96:

Question 15:

Explain why G − T = (Sg − I) − (X − M).

ANSWER:

In a closed economy, savings and investments are equal at equilibrium level of income. However, in an open
economy savings and investments differ.

Y=C+I+G+X−M

or, Y = C + I + G + NX [as NX = X − M]

or, Y − C − G = I + NX ...(1)

Now, the component on the LHS can be regarded as national savings. That is, net national income which is left after
consumption and government spending. Getting back to the equation (1), we can say:

S = I + NX

National savings (S) can be segregated into Private Savings (SP) and Government Savings (Sg).

so, SP + Sg = I + NX

or, NX = SP + Sg − I

or, NX = (Y − C − T) + (T − G) − I

or, NX = Y − C − T + T − G −I

or, NX = Y − C − G − I

or, G = Y − C − I − NX

or, G − T = Y − C − I − NX − T [Subtracting T from both sides]

or, G − T = Y − C − T − I − NX

or, G − T = (SP − I) − NX

Note : There is a misprint in the question as the equation mentions Sg instead of SP. The correct equation
is G − T = (SP − I) − NX.
 Page No 96:

Question 16:

If inflation is higher in country A than in Country B, and the exchange rate between the two
countries is fixed, what is likely to happen to the trade balance between the two countries?
ANSWER:

Country A has a higher inflation than country B. Since, the exchange rate is fixed, it is
advantageous for country B to export goods to country A. Similarly, it is advantageous for
country A to import goods from country B. On the other hand, it would be expensive for
country A to export goods to country B. Thus, country A will have trade deficit as it will
import more goods as compared to exports, from country B. Country B will import less
goods as compared to exports, from country A. Hence, there is a trade surplus in country B.

Page No 96:

Question 17:

Should a current account deficit be a cause for alarm? Explain.

ANSWER:

Current account deficit is the excess of total imports of goods, services and transfers over
total exports of goods, services and transfers. This situation makes a country debtor to the
rest of the world. But, this cannot be always treated as a cause for alarm because countries
might be running in deficits (current account) to increase productivity and exports in future.
Also, more investment will help in building capital stock, which in future will lead to rise in
output.

Page No 96:

Question 18:

Suppose C = 100 + 0.75Y D, I = 500, G = 750, taxes are 20 per cent of income, X =
150, M = 100 + 0.2Y. Calculate equilibrium income, the budget deficit or surplus and the
trade deficit or surplus.
ANSWER:

C = 100 + 0.75YD
I = 500

G = 750

X = 150

M = 100 + 0.2Y

Equilibrium income (Y) = C + c (Y −T) + I + G + X − M − mY

Or, Y = 100 + .75 + 500 +750 + 150 − 100 − 0.2Y

Or,

Or,

Or,

Or,

Government expenditure = 750

Government receipts (taxes)

Since, government expenditure > government receipts

It shows the government is running budget deficit

NX = X − M − MY
= 150 − 100 − 466.66

= 150 − 566.66

= − 416.66

Since NX is negative, it implies trade deficit.

Page No 96:

Question 19:

Discuss some of the exchange rate arrangements that countries have entered into to bring
about stability in their external accounts.
ANSWER:

To combine the two extreme positions, `fixed’ and ‘flexible’, the following exchange rate
arrangements are used by governments to bring stability in external accounts:

1. Wider Bands

A system that allows adjustment in fixed exchange rate is referred to as wider bands. It
permits only 10% variation between the currencies of any two countries. For example, a
country can improve its balance of payments (BoP) deficit by depreciating it’s currency,
which leads to increase in demand for domestic goods due to increase in purchasing power
of other currencies. This further leads to the increase in exports, hence improving the BoP.

2. Crawling Peg

Crawling peg system allows continuous and regular adjustments in the exchange rate. Only
1% of variation is allowed at a time.

3. Managed floating

Managed floating is a scheme under which government can intervene to vary the exchange
rate when the situation demands so. There is no specific limit of variation as in crawling peg
and wider bands.
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