DEY's Balance of Payments PPTs As Per Revised Syllabus (Teaching Made Easier

 Balance of payments account – meaning
and components
 Foreign exchange rate – meaning of fixed
and flexible rates and managed floating
Balance of Payments: Meaning and
5.1
Components
Meaning of Balance of Payments
Balance of Payments (BoP) is defined as the statement
of accounts of a country’s inflows and outflows of
foreign exchange in a fiscal year. (Foreign exchange or
foreign currency refers to any currency other than the
domestic currency.)
There are two main accounts in the BoP – the current
account and the capital account. Current account is
the record of trade in goods and services and transfer
payments, whereas capital account records all
international transactions of assets, e.g. money, stocks,
bonds, government debt, etc.
Since it is difficult to record all international economic
transactions accurately, therefore we have a third
element of BoP (apart from the current and capital
accounts) called errors and omissions which reflects
this.
Debit Side
Any international transaction which results in outflow
of foreign exchange is recorded on the debit side in the
balance of payments accounts (the current account and
or capital account). It is given a negative sign.
For example, payments for imports of goods and services,
purchase of financial assets (e.g. shares, debentures,
bonds, etc.) in a foreign country, etc.
Buying
Top Tip
foreign goods (i.e. import) is expenditure from our country
and it becomes the income of that foreign country. Hence, it is a
debit item of the current account of balance of payments.
Note that imports decrease the domestic demand for goods and
services in our country.
Credit Side
Any international transaction which leads to inflow of
foreign exchange is recorded on the credit side in the
balance of payments accounts (the current account or
the capital account). It is given a positive sign.
For example, receipts on account of exports of goods
and services, foreign investments, factor income earned
from abroad, loans and grants from abroad, etc.
 Top Tips
 Selling of domestic goods to foreign nationals, i.e. export,
brings income to our country. Hence, it is a credit item of
the current account of balance of payments. Note that
exports add to the aggregate domestic demand for goods
and services in our country.
 Foreign investments lead to inflow of foreign exchange.
Hence, it is recorded on the credit side of the capital
account since it is an international transactions of assets.
Note that foreign investments are divided into Foreign
Direct Investment (FDI) and Portfolio investment. While FDI
involves foreign investors taking a controlling and lasting
stake in productive enterprises, portfolio investments
represent holdings of minor equity (without management
control) or debt through the stock markets by foreign
investors for the purpose of earning return on investment.
Current Account of BoP
Current Account is the record of trade in goods and
services and transfer payments.
Components of the Current Account
1. Trade in goods: It includes (i) exports of goods
and (ii) imports of goods.
For example, export or import of machinery.
2. Trade in services: Services trade includes both
net factor income and net non-factor income
transactions.
(i) Net factor income: Net factor income
includes net international earnings of factors
of production (like labour, land and capital).
Examples:
• Net income from compensation of employees
• Net investment income, i.e., interest, profits and
dividends on our assets abroad minus the income
foreigners earn on assets they own in India.
(ii) Net non-factor income: Net non-factor income is
net sale of service products like shipping, banking,
tourism, software services, etc.
3. Transfer payments: Foreign transfers are the
receipts which the residents of a country get for
‘free’, without having to provide any goods or
services in return. They consist of gifts, remittances
and grants. They could be given by the government
or by private citizens living abroad.
Balance on Current Account
Balance on Current Account has two components: (i)
Balance of Trade or Trade Balance and (ii) Balance on
Invisibles.
1. Balance of Trade (BoT)/Trade Balance: It is the
difference between the value of exports and imports
of goods of a country during a year.
Balance of Trade (BoT) = Value of exports of goods –
Value of imports of goods
 Top Tips
Exports and imports of goods is also called visible trade.
Export of goods is entered as a credit item in BoT as it
leads to inflows of foreign exchange whereas import
of goods is entered as a debit item in BoT as it results
in outflow of foreign exchange.
 BoT is said to be in balance when exports of goods
are equal to the imports of goods.
 Surplus BoT or Trade surplus will arise if the total
value of country’s exports of merchandise (goods)
is more than value of its imports of the
merchandise during a year.
 Deficit BoT or Trade deficit will arise if the total
value of country’s imports of merchandise (goods)
is more than value of its exports of the merchandise
during a year.
2. Balance on Invisibles: Net invisibles is difference
between the value of exports and imports of
invisibles of a country in a given period of time.
Invisibles include services, transfers and flows of
income.
 Current account is in balance when receipts on
current account are equal to the payments on the
current account.
 Current Account Surplus (CAS) refers to excess
of receipts from value of export of visible items,
invisible items and unilateral transfers over
payments for value of import of visible items,
invisible items and unilateral transfers.
CAS is relatively broader concept as compared to
trade surplus.
CAS signifies that the nation is a lender to the
rest of the world.
 Current Account Deficit (CAD) arises when the
value of exports of visible items, invisible items
and unilateral transfers is less than the value of
imports of visible items, invisible items and
unilateral transfers.
CAD is relatively broader concept as compared
to trade deficit.
CAD signifies that the nation is a borrower from
the rest of the world.
 Top Tip
Difference between Balance on Trade Account and
• 'Balance on Trade Account' is the difference between
value of exports of goods and imports of goods. In other
words, it is the difference between visible inflows and
visible outflows of foreign exchange.
• 'Balance on Current Account' is the sum total of balance
of trade and balance on invisibles. In other words, it is the
difference between the sum of both visibles and invisibles
inflows and outflows of foreign exchange.
Capital Account of BoP
Capital account records all international transactions of
assets. An asset is any one of the forms in which wealth
can be held, for example, money, stocks, bonds,
government debt, etc.
 Capital inflows such as receipt of loans from
abroad, sale of assets or shares in foreign
companies, etc. are recorded on the credit side of
the capital account as there is inflow of foreign
exchange in India.
 Capital outflows such as repayment of loans,
purchase of assets or shares in foreign countries,
etc. are recorded on the debit side of the capital
account as it results in outflow of foreign exchange.
Components of Capital Account
There are three components of the capital account —
Foreign Investments, External Borrowings and External
Assistance.
1. Foreign Investments: Foreign investments may be
of two kinds:
(a) Direct Investment, e.g. Foreign Direct
Investments (FDIs), Equity Capital, Reinvested
Earnings and other Direct Capital Flows.
(b) Portfolio Investment, e.g. Foreign Institutional
Investments (FIIs), Offshore Funds, etc.
2. External Borrowings: Examples: External Commercial
Borrowings, Short-term Debt, etc.
3. External Assistance: Examples: Government Aid,
Inter-governmental, Multilateral and Bilateral Loans.
Balance on Capital Account
Balance on Capital Account is the sum total of net
foreign investments, net external borrowings and net
external assistance.
 Capital account is in balance when capital inflows
(like receipt of loans from abroad, sale of assets or
shares in foreign companies) are equal to capital
outflows (like repayment of loans, purchase of
assets or shares in foreign countries).
 Surplus in capital account arises when capital
inflows are greater than capital outflows.
 Deficit in capital account arises when capital
inflows are lesser than capital outflows.
Key Term
Foreign exchange — Any currency other than the domestic
currency.
Balance of Payments (BoP) — The statement of accounts of a
country’s inflows and outflows of foreign exchange in a fiscal year.
Debit — Any international transaction which results in outflow of
foreign exchange is entered as a debit in BoP accounts.
Credit — Any international transaction which results in inflow of
foreign exchange is entered as a credit in BoP accounts.
Current Account — The record of trade in goods and services and
transfer payments.
Capital Account — The record of all international transactions of
assets, e.g. money, stocks, bonds, government debt, etc.
Factor income — Net international earnings on factors of
production (like labour, land and capital).
Non-factor income — Net sale of service products like shipping,
banking, tourism, software services, etc.
Balance of Trade (BoT) — The difference between the value of
exports and imports of goods of a country in a given period of time.
Invisibles — Services, transfers and flows of income that take
place between different countries.
Current Account Surplus (CAS) — A situation that arises when
the receipts on current account are more than the payments on
current account.
Current Account Deficit (CAD) — A situation that arises when the
receipts on current account are less than the payments on
current account.
Balance on Current Account — Sum total of balance of trade and
balance on invisibles.
Balance on Capital Account — Sum total of net foreign investments,
net external borrowings and net external assistance.
Foreign Investments—Foreign Direct Investments (FDIs), Portfolio
Investment, e.g. Foreign Institutional Investments (FIIs).
External Borrowings — External Commercial Borrowings, Short-
term Debt.
External Assistance — Government Aid, Inter-governmental,
Multilateral and Bilateral Loans.
Surplus in capital account — Capital inflows (like receipt of loans
from abroad, sale of assets or shares in foreign companies) are
greater than capital outflows (like repayment of loans, purchase
of assets or shares in foreign countries).
RECAP
Balance of Payments
Balance of Payments is defined as the statement of
accounts of a country’s inflows and outflows of foreign
exchange in a fiscal year. Foreign exchange refers to any
currency other than the domestic currency.
There are two main accounts in the BoP – the current
account and the capital account. Current Account is the
record of trade in goods and services and transfer
payments. Capital Account records all international
transactions of assets, e.g. money, stocks, bonds,
government debt, etc.
 Any transaction which results in outflow of foreign
exchange is recorded on the debit side in the balance of
payments accounts (the current account and the capital
account), e.g. imports.
 Any transaction which leads to inflow of foreign exchange
is recorded on the credit side in the balance of payments
accounts, e.g. exports.
Components of Current Account
1. Trade in goods: It includes:
(i) exports of goods and (ii) imports of goods.
2. Trade in services: Services trade includes both factor
income and non-factor income transactions.
 Factor income includes net international earnings on
factors of production (like labour, land and capital).
For example, net income from compensation of
employees and net investment income, e.g., profits
from investments made abroad.
 Non-factor income is net sale of service products like
shipping, banking, tourism, software services, etc.
3. Transfers payments: The receipts which the residents of
a country get for ‘free’, e.g. gifts, remittances and grants.
Components of Balance on Current Account
1. Balance of Trade/Trade Balance: The difference between
the value of exports and imports of goods of a country
during a year.
 Trade surplus will arise if the total value of country’s
exports of merchandise (goods) is more than value of
its imports of the merchandise during a year.
 Trade deficit will arise if the total value of country’s
imports of merchandise (goods) is more than value of
its exports of the merchandise during a year.
2. Balance on Invisibles: The difference between the value
of exports and imports of invisibles of a country in a given
period of time. Invisibles include services, transfers and
flows of income.
Current Account Surplus (CAS) refers to excess of receipts
from value of export of visible items, invisible items and
unilateral transfers over payments for value of import of visible
items, invisible items and unilateral transfers. It is relatively
broader concept as compared to trade surplus. CAS signifies
that the nation is a lender to the rest of the world.
Current Account Deficit (CAD) arises when the value of
exports of visible items, invisible items and unilateral transfers
is less than the value of imports of visible items, invisible items
and unilateral transfers. It is relatively broader concept as
compared to trade deficit. CAD signifies that the nation is a
borrower from the rest of the world.
Capital Account
Capital Account records all international transactions of
assets, e.g. money, stocks, bonds, government debt, etc.
It has three components:
1. Foreign Investments: (i) Direct Investment, e.g. Foreign
Direct Investments (FDIs) (ii) Portfolio Investment, e.g.
Foreign Institutional Investments (FIIs).
2. External Borrowings, e.g. External Commercial
Borrowings, Short-term Debt.
External Assistance, e.g. Government Aid, Inter-
governmental, Multilateral and Bilateral Loans.
Balance on Capital Account
Surplus in capital account arises when capital inflows (like
receipt of loans from abroad, sale of assets or shares in
foreign companies) are greater than capital outflows (like
repayment of loans, purchase of assets or shares in foreign
countries).
Deficit in capital account arises when capital inflows are
lesser than capital outflows.
Question 1
What does the Balance of payments (BoP) accounts record?
(a) Transactions in goods, services and assets between
residents of a country with the rest of the world
during a fiscal year.
(b) Transactions in foreign exchange assets and liabilities
during a fiscal year.
(c) Inflows and outflows of foreign exchange during a
fiscal year.
(d) None of these
Objective Type Questions 5.1
Answer 1
(c) Inflows and outflows of foreign exchange during a
fiscal year.

Question 2
________ of Balance of payments (BoP) is the record
of trade in goods and services and transfer payments.
(Current Account/Capital Account)
(Fill in the blank with correct option)

Answer 2
Current Account

Question 3
Which of the following is true for Transfer Payments in
the Current Account of Balance of Payments?
(Choose the correct alternative)
(a) Transfer payments are the receipts which the
residents of the country get for free, without having
to provide any goods and services in return.
(b) They consist of gifts, remittances and grants.
(c) They could be given by the government or by
private citizen living abroad.
(d) All of these
Answer 3
(d) All of these

Question 4
“Domestic demand for goods and demand for domestic
goods are one and the same thing.”
True/False? Give reason.

Answer 4
False: In an open economy, aggregate demand for
domestic goods equals domestic demand for goods
(consumption investment and government spending)
plus exports and minus imports.
Purchase of foreign goods (i.e. imports) decreases the
domestic demand for goods of our country; whereas
exports adds to the demand for domestic goods.

Question 5
Which of the following is not a component of the current
account of Balance of Payments?
(a) Exports and imports of goods and services
(b) Remittances given by private citizens living abroad
(c) Net international income from compensation of
employees
(d) None of the above

Answer 5

Question 6
Current Account Deficit (CAD) means:
(a) The value of exports of goods and services is less
than the value of imports of goods and services.
(b) The nation is a borrower from other countries.
(c) Both (a) and (b)
(d) The nation is a lender to other countries.

Answer 6

Question 7
Current Account Surplus (CAS) means:
(a) The value of exports of goods is more than the
value of imports of goods.
(b) The nation is a lender to the rest of the world
(d) The nation is a borrower from other countries.

Answer 7
(b) The nation is a lender to the rest of the world

Question 8
_____________ is the difference between the value of
exports and value of imports of goods of a country in a
given period of time.
(Fill in the blank)

Answer 8
Balance of Trade (BoT) or Trade Balance

Question 9
Exports of goods is entered as a _____ item in Balance
of Trade (BoT), whereas import of goods is entered as a
______ item in BoT. (debit/credit)
(Fill in the blanks with correct option)

Answer 9
(i) credit
(ii) debit

Question 10
__________ will arise if a country imports more goods
than what it exports. Whereas, ___________ will arise if
the country exports more goods than what it imports.
(Fill in the blanks)

Answer 10
(i) Deficit BoT or Trade Deficit
(ii) Surplus BoT or Trade Surplus

Question 11
__________ is the difference between the value of
exports and value of imports of services, transfers and
flows of income of a country in a given period of time.
(a) Balance of Trade
(b) Net invisibles
(c) Trade Surplus
(d) Current Account Surplus

Answer 11
(b) Net invisibles

Question 12
_______________ of Balance of Payments records all
international transactions of assets.
(Fill in the blank)

Answer 12
Capital Account

Question 13
Capital Account of BoP records all international
transactions of assets. Which of the following is
not included in assets?
(a) Money
(b) Stocks and bonds
(c) Machinery
(d) Government debt

Answer 13
(c) Machinery

Question 14
If an Indian buys a UK Car Company, it enters ________
(Current Account/Capital Account) of Balance of
Payments as a _________ (debit/credit) item.
(Fill up the blanks with correct option)

Answer 14
(i) Capital Account (since it is an international
transaction of assets)
(ii) Debit (as foreign exchange is flowing out of India)

Question 15
Sale of share, of an Indian Company to a Chinese
customer is a ___________ (debit/credit) item on
the _______________ (Current Account/Capital
Account) of Balance of Payments.

Answer 15
(i) credit (as it leads to inflow of foreign exchange into
the country)
(ii) Capital account (since it is an international transaction
of assets)

Question 16
Which of the following is not included in the capital
account of the Balance of Payments?
(a) Foreign Direct Investments (FDIs)
(b) Foreign Institutional Investments (FIIs)
(c) External assistance

Answer 16

Question 17
Foreign Investments include:
(a) Direct Investment, e.g. FDI, Equity Capital, Reinvestment
earnings and other Direct Capital Flows:
(b) Portfolio Investment, e.g. FII, off share Funds
(d) Neither (a) nor (b)

Answer 17

Question 18
___________ in capital account arises when capital
inflows (like receipt of loans from abroad, sale of assets
or share in foreign companies) are greater than capital
outflows (like repayment or loans, purchase of assets or
shares in foreign countries), whereas, __________ in
capital account arises when capital inflows are lesser than
capital outflows. (Deficit/Surplus)

Answer 18
(i) Surplus
(ii) deficit

Question 19
Receipts of loans from abroad is recorded as a ________
(debit/credit) item in the _____ (Current account/capital
account) of Balance of Payments.

Answer 19
(i) Credit
(ii) Capital account

Question 20
Which of the following is not recorded in the Capital
Account of Balance of Payments?
(a) Equity capitals
(b) Gifts, Remittances and Grants
(c) Government Aid
(d) Offshore Funds

Answer 20
(b) Gifts, Remittances and Grants

Question 21
Which of the following is recorded in the capital account
of Balance of Payments?
(a) Reinvested Earnings
(b) Inter-governmental multilateral and bilateral loans
(c) Short term debt
(d) All of these

Answer 21
(d) All of these

Question 22
It is difficult to record all international transactions
accurately. Thus, a third element of BoP (apart from the
current and capital accounts), called ______________
reflects this.
(Fill in the blank)

Answer 22
Errors and omissions

Question 23
An increase in foreign income improves the trade balance.

Answer 23
True: An increase in foreign income leads to increased
exports.
Thus, trade balance (= exports of goods – imports of
goods) increases.

Question 24
_________ is the sum of the balance of merchandise
trade, services and net transfers received from the rest
of the world.

Answer 24
Current Account balance

Question 25
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 two
countries? (Choose the correct alternative)
(a) Trade balance of country A will share a deficit whereas
trade balance of country B will show a surplus.
(b) Trade balance of country A will show a surplus
whereas trade balance of country B will show a deficit.
(c) Balance of trade of both the countries will be in
balance
Answer 25
(a) Trade balance of country A will share a deficit whereas
trade balance of country B will show a surplus.
Hint: Effect on trade balance of country A
Since prices of goods in country A are more than that
in country B, it exports will decrease an imports will
increase. Thus, trade balance (= exports of goods –
imports of goods) will show a deficit.
Effect on trade balance of country B
Its exports of goods will increase and imports of
goods will decrease. Thus, trade deficit will show a
surplus.
Question 26
Interest on loan received from Nepal is recorded on
the _____________ (debit side/credit side) of the
__________ (current account/capital account) of the
Balance of Payments.

Answer 26
(i) Credit side
(ii) Current account
Hint:
Credit side; as brings foreign exchange into the country
Current account; as it is a part of net factor income
(net investment income).

Question 27
Import of mobile phones from China is recorded on
the ____________ (debit side/credit side) of the
__________ (current account/capital account) of the
Balance of Payments.

Answer 27
(i) Debit side
(ii) Current account
Hint:
Debit side; as it represents outflow of the foreign
exchange from the country
Current account; as it is an import of goods/visibles.

Question 28
A company located in India receives a loan from a company
located abroad. How is this transaction recorded in India’s
balance of payments account?
(CBSE 2017) (Choose the correct alternative)
(a) Credit side of current account
(b) Debit side of current account
(c) Credit side of capital account
(d) Debit side of capital account

Answer 28
(c) Credit side of capital account

Question 29
An Indian company located in India invests in a company
located abroad. This transaction is entered in India’s
balance of payments account on:
(CBSE 2017) (Choose the correct alternative)
(a) credit side of current account
(b) debit side of current account
(c) credit side of capital account
(d) debit side of capital account

Answer 29
(d) debit side of capital account

Question 30
Which of the following will be entered as a Credit item
in the Balance of Payments of a country?
(a) Imports of goods and services
(b) Portfolio investments
(c) Purchase of foreign securities
(d) Transfer payments

Answer 30
(b) Portfolio investments

Question 31
Which of the following items is not included in the current
account of the Balance of Payments of a country?
(a) Interest, profits and dividends on assets abroad
(b) Income from software services
(c) Remittances from abroad
(d) Foreign direct investment

Answer 31
(d) Foreign direct investment

Question 32
State, giving reason, whether the following
statement is true or false:
Difference between value of exports and imports of
goods and services is called trade balance.

Answer 32
False: Trade balance is the difference between value of
exports of goods and imports of goods only. It does not
include exports and imports of services.

Question 33
External assistance is recorded in the current account of
the Balance of Payments.

Answer 33
False: External assistance (e.g. Government aid, Inter-
governmental, Multi-lateral and Bilateral Loans) is recorded
in the capital account of the Balance of Payments.

Question 34
Export and import of machines are recorded in capital
account of the balance of payments account.

Answer 34
False: Export and import of machines is the export and
import of goods. Therefore, it is recorded in the Current
account of the Balance of Payments account.

Question 35
Foreign investments are recorded in the capital account of
balance of payments.

Answer 35
True: Foreign investments, e.g., foreign direct investment
are the international transactions of assets during a fiscal
year. Therefore, foreign investments are recorded in the
capital account of balance of payments.

Question 36
In balance of payments, repayment of loans by Indian
government to US Government will be recorded on
the credit side of current account.

Answer 36
False: It will be recorded in the capital account since
loan from US Government is an international liability.
The repayment of loans results in outflow of foreign
exchange. Therefore, it will be recorded on the debit
side.

Question 37
In the context of balance of payments of a country,
state whether the following statement is true or
false. Give reason for your answer.
Profits received from investments abroad is recorded in
capital account.

Answer 37
False: Profits received from investments abroad is
recorded in the current account since it is an investment
income (factor income). Factor income includes net
international earning of factors of production.
It will be recorded on the credit side of the current
account since it leads to inflow of foreign exchange.

Question 38
In the context of balance of payments of a country,
state whether the following statement is true or
false. Give reason for your answer.
Import of machines is recorded in current account.

Answer 38
True: All imports and exports of goods are recorded in
the current account. Import of machines is simply import
of a good.

Question 39
The current account of BoP includes transactions related
to:
(a) Financial assets
(b) Borrowing from foreign countries
(c) Export and import of invisible items
(d) Foreign investment

Answer 39
(c) Export and import of invisible items

Question 40
Which one is the component of current account of BoP?
(a) Invisibles
(b) Foreign Direct Investment
(c) Banking Capital
(d) Loans

Answer 40
(a) Invisibles

Question 41
Which of the following items are included in current
account BoP?
(a) Foreign Investment
(b) External Borrowings
(c) External Assistance
(d) Non-factor income

Answer 41
(d) Non-factor income

Question 42
Borrowing and lending money in international money
market is a part of current account in BoP.

Answer 42
False: Borrowing and lending money in international
money market is a part of capital account in BoP.

Question 43
Purchase of shares of a foreign company are included
in credit side of Capital account.

Answer 43
False: It is recorded on the debit side of capital account
of BoP as there will be outflow of foreign exchange.

Question 1
“A country with trade deficit cannot have current account
surplus in its Balance of Payments”. Do you agree with
given statement? Discuss with reason.
(CBSE 2019) (3 marks)
HOTS — Analysing, Evaluating & Creating Type Questions

Answer 1
No, trade deficit occurs when value of goods/visibles
imported is more than the value of goods/visibles
exported.
Trade deficit = Value of imports(Vm) < Value of
exports (Vx)
Trade Surplus in this situation will arise when the
deficit on trade account is less than the surplus on
account of invisibles.

Question 2
State on which side of capital account/current account
will the following transactions be recorded and why:
(i) Interest on loan received from Nepal
(ii) Import of mobile phones from China

Answer 2
(i) Interest on Loan received from Nepal - It will be
recorded on the credit side of the current account
as it brings in funds to the country.
(ii) Import of mobile phones from China - It will be
recorded in the debit/payment side of the current
account as it is represents outflow of the foreign
currency through visible imports.

Question 3
Distinguish between Balance of Trade and Balance of
Payments.
(3 marks)

Answer 3
Balance of Trade (or trade balance) is the difference
between value of exports and imports of goods. Its
scope is narrower since it records transactions in
goods only.
Balance of payments is an account which records the
transactions in goods, services, incomes, transfers and
assets between residents of a country with the rest of
the world. It reveals the true picture of a country’s
international transactions.

Question 4
Where will sale of machinery to abroad be recorded in
the Balance of Payments Accounts? Give reasons.

Answer 4
Sale of machinery to abroad is export of goods and thus
recorded in the Current Account. Sale of machinery to
abroad brings in foreign exchange and thus recorded on
the credit side.

Question 5
In which sub-account and on which side of balance of
payments account, will foreign investments in India be
recorded? Given reasons.
(3 marks)

Answer 5
Foreign investment will be recorded in the capital account
of the balance of payments 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.

Question 6
In which sub-account and on which side of balance of
payments account, will Profits received from investments
abroad be recorded? Given reasons.
(3 marks)

Answer 6
Profits received from investments abroad is recorded in
the current account since it is an investment income
(factor income).Factor income includes net international
earning of factors of production.

Question 7
Where will (a) import of machinery and (b) charity to
foreign countries be recorded in the Balance of Payments?
Give reasons.
(4 marks)

Answer 7
(a) Imports of Machinery is recorded as visible items in
the current account, because it is simply import of a
good. It is recorded as a debit item because it leads to
outflow of foreign exchange.
(b) Charity to foreign countries is recorded in the current
account of BoP because it is a transfer payment. It is
recorded on the debit side because it leads to outflow
of foreign exchange.

Question 8
Where will (a) Remittances from family members from
abroad and (b) Borrowings from abroad be recorded in
the Balance of Payments? Give reasons.
(4 marks)

Answer 8
(a) Remittances from family members from abroad is
accounted for under unilateral transfers of the current
account. It is recorded on the credit side because it
brings in foreign exchange into the country.
(b) ‘Borrowings from abroad’ is recorded in the ‘capital
account’ of BoP because it increases international
liability of the country. It is recorded on the credit side
because it brings in foreign exchange into the country.

Question 9
Are the following entered (i) on the credit side or the
debit side and (ii) in the current account or capital
account in the Balance of Payments? You must give
reason for your answer.
(a) Transfer of funds to relatives abroad.
(b) Imports of Petroleum, Oil and Lubricants (POL)
(4 marks)

Answer 9
(a) It is a transfer payment which results into outflow of
foreign exchange from the country, so it is recorded
on the debit side of the Current account of Balance
of Payments (BoP).
(b) Imports of Petroleum, Oil and Lubricants (POL) is
the imports of goods, which involve outflow of
foreign exchange from the country, so it is recorded
on the debit side of the Current account of BoP.

Question 10
In the context of balance of payments account, state
whether the following statements are true or false. Give
reasons for your answer.
(a) Profits received from investments abroad is recorded
in capital account.
(b) Import of machines is recorded in current account.

Answer 10
(a) False: Profits received from investments abroad is
recorded in the current account since it is an
investment income (factor income). Factor income
includes net international earning of factors of
production.
(b) True: All imports and exports of goods are recorded
in the current account, because it is simply import/
export of a good.

Question 11
Giving reason explain how the following will be entered
in (i) current account or capital account and (ii) on
credit side or debit side of balance of payments:
(a) Imports of machinery
(b) Investments from abroad

Answer 11
(a) Imports of Machinery
(i) Recorded as visible items in the current account,
because it is simply an import of a good.
(ii) Recorded on debit side because it leads to
outflow of foreign exchange.
(b) Investments from abroad
(i) Recorded in capital account because it is a
transaction in assets.
(ii) Recorded on credit side because it leads to inflow
of foreign exchange.
Question 12
Given the exchange rate, what is the effect of fall in
domestic prices on aggregate demand?
(3 marks)

Answer 12
If prices of domestic goods fall, exports become cheaper.
So, domestic exports will increase. Since exchange rate
remains constant, imports remain unchanged. As a result,
net exports (i.e., exports – imports) will increase. Since
net exports is a component of aggregate demand,
therefore, aggregate demand will increase.

Question 13
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? Explain.
(3 marks)

Answer 13
Effect on trade balance of country A: Since prices of
goods in country A are more than that in country B, its
exports to country B will decrease and imports from
country B will increase.
Thus, trade balance (i.e., value of exports of goods –
value of imports of goods) will show a deficit.
Effect on trade balance of country B: Since price of goods
in country B are relatively less than that in country A, its
exports to country A will increase and imports from
country A will decrease. Thus, trade balance will show a
surplus.
Question 14
What will be the effect of the following on the Balance
of Payments of India?
(a) ‘Make in India’ Programme
(b) Import of Pulses
(3 marks)

Answer 14
(a) ‘Make in India’ will increase supply (inflow) of
foreign exchange in India, causing improvement in
the balance of payments position.
(b) Import of pulses will lead to outflow of foreign
exchange from the country, causing adverse effect
on balance of payment position.

NUMERICAL 1
If the value of exports of goods of a country is `1,000 crore

and the value of imports of goods is `1,650 crore, calculate
the trade balance of the country. (1 mark)
Solution: Trade balance or Balance of trade
= Value of exports of goods – Value of imports of goods
= 1,000 – 1,650 = (–)`650 crore
Thus, there is a trade deficit of `650 crore.
Do it yourself 1
If the value of exports of merchandise of a country is `800
crore and the value of imports of merchandise is `650 crore,
calculate the trade balance of the country. (1 mark)
[Ans. Trade surplus of `150 crore]
NUMERICAL 2
If the balance of trade of a country is showing a deficit of `400

crore and the value of imports of goods is `1,100 crore, then
what is the value of exports of goods? (1 mark)
Solution: Trade balance or Balance of trade = Value of exports
of goods – Value of imports of goods
Since there is trade deficit of `400 crore, trade balance = (–)
`400 crore and value of imports of goods = `1,100 crore,
therefore, (–) `400 crore = Value of exports of goods – `1,100
crore Value of exports of goods = – 400 + 1,100 = `700 crore
Do it yourself 2
If a country has trade surplus of `200 crore and the value of
exports of goods is `700 crore, then what is the value of
imports of goods? [Ans. `500 crore] (1 mark)
Foreign Exchange Rate – Fixed and
5.2
Flexible Rates and Managed Floating
Foreign exchange or foreign currency refers to any
currency other than the domestic currency.
The market in which national currencies are traded for
one another is known as the foreign exchange market.
The major participants in the foreign exchange market
are commercial banks, foreign exchange brokers and
other authorised dealers and monetary authorities.
It is important to note that although participants
themselves may have their own trading centres , the
market itself is world-wide. There is a close and
continuous contact between the trading centres and
the participants deal in more than one market.
Foreign Exchange Rate
Foreign Exchange Rate (also called 'Forex Rate') is the
price of one currency in terms of another. It links the
currencies of different countries and enables comparison
of international costs and prices. For example, if we have
to pay 70 rupees for one dollar, then the exchange rate is
`70/$.
Foreign exchange rate is the rate at which one currency
can be converted into another currency.
Different countries have different methods of determining
their currency’s exchange rate. It can be determined through
Flexible Exchange Rate, Fixed Exchange Rate or Managed
Floating Exchange Rate.
Flexible (or Floating) Exchange Rates
An exchange rate determined by the forces of demand
and supply in the foreign exchange market is flexible or
floating exchange rate.
In a completely flexible exchange rate system (i.e. clean
floating), the central banks do not intervene in the
foreign exchange market.
A central bank does not maintain any reserves of foreign
currency as the market automatically adjusts to determine
the market driven exchange rate. Therefore, there are no
official reserve transactions.
Demand for Foreign Exchange in the foreign
exchange market
People demand foreign exchange because of the following
reasons. These are sources of demand because these lead
to outflow of foreign exchange.
(i) Imports: Importers need foreign exchange for
making payments for buying goods and services
from abroad.
(ii) Foreign transfer payments: For transfer payments
to any other country in the form of gifts, grants or
remittances, etc. foreign currency is needed.
(iii) Investments abroad: For investment in other
countries, e.g. purchase of financial assets like shares,
bonds, etc. abroad, foreign currency is needed.
(iv) Tourism abroad: Foreign currency is needed for
foreign travel, for example, Indian people visiting
abroad on a vacation say, for sight-seeing etc.
(v) Foreign exchange speculation: Another reason for
the demand for foreign exchange is for speculative
purposes. Foreign exchange is demanded for the
possible gains from appreciation of the foreign
currency. If speculators believe that the British
pound is going to increase in value relative to the
rupee, they will want to hold pounds. For instance,
if the current exchange rate is `90/£ and investors
believe that the pound is going to appreciate by
the end of the month and will be worth `95 (i.e.,
exchange rate will rise to `95/£), investors think if
they took `90000 and bought 1000 pounds, at the
end of the month, they would be able to exchange
the pounds for `95000, thus making a profit of
`5000. This expectation would increase the demand
for pounds in the foreign exchange market.
Inverse/Negative Relationship between
Foreign exchange rate and demand for
Foreign exchange
A rise in price of foreign exchange causes decrease in
demand for foreign exchange and vice-versa.
Explanation: A rise in price of foreign exchange will
increase the cost (in terms of rupees) of purchasing a
foreign good. For example, if rupee-dollar exchange rate
rises from `70/$ to `75/$, Indians have to pay more
rupees to import US goods. This reduces demand for
imports of foreign goods (US goods). This results in less
outflow of foreign exchange from India. Therefore,
demand for foreign exchange (Dollars) decreases, other
things remaining constant.
Sources of supply of foreign exchange in the
foreign exchange market
Foreign currency flows into the home country due to the
following reasons. These are sources of supply because these
lead to inflow of foreign exchange.
(i) Exports: All exports of goods and services by domestic
residents bring foreign exchange into the country.
(ii) Foreign Investments: Foreign Direct Investment
(FDI), Portfolio Investments, e.g. Foreign Institutional
Investment (FII) add to the supply of foreign exchange
as these bring in foreign exchange into the country.
(iii) Foreign tourism: Foreign tourists coming to India,
say to visit Vrindavan bring foreign currency into the
country.
(iv) Other sources of supply of foreign exchange:
Factor income earned from abroad, Remittances
from abroad, e.g. NRIs send gifts or make
transfers, Loans and grants from abroad, Interest
received on loans to abroad, etc. are also received
in foreign currency.
Direct/Positive Relationship between
Foreign exchange rate and demand for
Foreign exchange
A rise in price of foreign exchange causes increase in
supply of foreign exchange and vice-versa.
Explanation: A rise in price of foreign exchange will
reduce the foreigners’ cost (in terms of foreign
currency) while purchasing goods from India, other
things remaining constant. For example, if rupee-dollar
exchange rate rises from `70/$ to `75/$, US dollars can
now buy more of domestic goods. That is, exported
goods become cheaper in the international market
giving a competitive edge for the goods of domestic
country (India). As exported goods become cheaper,
this increases exports of India. This results in more
inflow of foreign exchange. Therefore, supply of foreign
exchange (Dollars) increases, other things remaining
constant.
 Top Tip
Link between the balance of payments accounts and the
transactions in the foreign exchange market:
Outflow of foreign exchange on account of imports of goods
and services, investments made abroad, etc. (total debits in
the BoP accounts) represent the demand for foreign
exchange in the foreign exchange market.
Conversely, total credits in the BoP accounts, e.g., inflow of
foreign exchange for all exports of goods and services,
external borrowings, foreign investments, etc. represent the
supply of foreign exchange in the foreign exchange market.
Fixed Exchange Rates
Under fixed exchange rate system, the Government fixes
the exchange rate at a particular level. The Central Bank
actively uses its foreign exchange reserves to maintain the
officially determined exchange rate.
An exchange rate between the two currencies fixed at
government level is called fixed exchange rate.
The market determined exchange rate is `70/$. However,
let us suppose that for some reason the Indian
Government wants to encourage exports for which it
needs to make rupee cheaper for foreigners it would do so
by fixing a higher exchange rate, say `75 per dollar from
the current exchange rate of `70 per dollar. At this
exchange rate, the supply of dollars exceeds the demand
for dollars. The RBI intervenes to purchase the dollars
for rupees in the foreign exchange market in order to
absorb this excess supply which has been marked as
AB in the figure. Thus, through intervention, the
Government can maintain any exchange rate in the
economy. But it will be accumulating more and more
foreign exchange so long as this intervention goes on.
On the other hand, if the government was to set an
exchange rate at a lower level, there would be an excess
demand for dollars in the foreign exchange market. To
meet this excess demand for dollars, the government
would have to withdraw dollars from its past holdings
of dollars. If it fails to do so, a black market for dollars
may come up.
 Top Tips
Official reserve transactions are more relevant under a
regime of fixed exchange rates than when exchange rates
are floating.
Devaluation of domestic currency

In a fixed exchange rate system, when the government
increases the exchange rate (thereby, making domestic
currency cheaper in terms of a foreign currency) is called
Devaluation of domestic currency. In other words,
devaluation of domestic currency is reduction in the
value of domestic currency by the government with
respect to a given foreign currency.
Revaluation of domestic currency
In a fixed exchange rate system, when the government
decreases the exchange rate (thereby, making domestic
currency costlier in terms of a foreign currency) is called
Revaluation of domestic currency.
Managed Floating Exchange Rates
Without any formal international agreement, the world
has moved on to what can be best described as a managed
floating exchange rate system.
In a system of managed floating exchange rates, the
exchange rate is determined by the combined forces of
demand and supply of foreign exchange, but the Central
Bank may intervene to buy or sell foreign currencies in
order to control the exchange rate fluctuations. Official
reserve transactions are, therefore, not equal to zero.
Managed floating exchange rate is the floating (or flexible)
exchange rate which can be influenced by the intervention
of the Central Bank in the foreign exchange market.
Thus, managed floating exchange rate system is the
amalgamation of the flexible exchange rate system and
the fixed exchange rate system because managed
floating exchange rate is decided by market forces (the
float part) but remains within a specific range as
decided by central bank (the managed part).
 Top Tips
Managed floating exchange rate system is also called 'dirty floating'
as the clean floating rate is influenced by the intervention of the
Central Bank in the foreign exchange market.
Key Terms
Foreign exchange market – The market in which national
currencies are traded for one another is known as the foreign
exchange market.
Foreign exchange rate – Foreign Exchange Rate (also called
'Forex Rate') is the rate at which one currency can be
converted into another currency.
Flexible (or Floating) Exchange Rates – An exchange rate
determined by the forces of demand and supply in the
foreign exchange market is flexible or floating exchange rate.
Equilibrium exchange rate – Equilibrium exchange rate is
the rate at which market demand and supply of foreign
exchange are equal.
Fixed exchange rate – An exchange rate between the two
currencies fixed at government level is called fixed exchange
rate.
Devaluation of domestic currency – In a fixed exchange rate
system, when some government action increases the exchange
rate (thereby, making domestic currency cheaper) is called
Devaluation of domestic currency.
Revaluation of domestic currency – In a fixed exchange rate
system, when some government action decreases the
exchange rate (thereby, making domestic currency costlier) is
called Revaluation of domestic currency.
Managed floating exchange rate (also called 'dirty floating') –
Managed floating exchange rate is the floating (or flexible)
exchange rate which can be influenced by the intervention of
the Central Bank in the foreign exchange market.
Question 1
___________ links the currencies of different countries
and enables comparison of international costs and prices.
(Fill in the blank)

Answer 1
Foreign Exchange Rate (also called Forex Rate)

Question 2
The market in which national currencies are traded for
one another is known as the ____________.
(Fill in the blank)

Answer 2
Foreign exchange market

Question 3
Which of the following is a major participant in the foreign
exchange market?
(a) Commercial banks
(b) Foreign exchange brokers and other authorised dealers
(c) Monetary authorities
(d) All of the above

Answer 3

Question 4
People demand foreign exchange because:
(a) They want to import goods and services.
(b) They want to purchase financial assets from abroad
(c) They want to send gifts abroad

Answer 4

Question 5
Which of the following is not a source of supply of foreign
exchange?
(a) Exports
(b) Speculation
(c) Transfer receipts
(d) Foreign Direct Investment (FDI)

Answer 5
(b) Speculation

Question 6
Match the columns:
Column I Column II
(i) This exchange rate is determined (a) Fixed exchange rate
by the market forces of demand
and supply
(ii) This exchange rate is determined (b) Flexible exchange rate
by the market forces of demand
and supply, with central bank
intervention to buy and sell
foreign currencies in an attempt
to moderate exchange rate
movements.
(iii) This exchange rate is fixed by the (c) Managed floating exchange rate
Government at a particular level.
Answer 6
(i) – (b), (ii) – (c), (iii) – (a)

Question 7
Under managed floating official reserve transactions are
equal to zero.

Answer 7
False: In case of managed floating, central banks intervene
to reduce fluctuations in the exchange rate.
Official reserve transactions are, therefore not equal to
zero. However, under clean floating, the exchange rate is
market determined without any central bank intervention.
So, official reserve transactions are equal to zero.

Question 8
Without any formal international agreement the world
had moved on to what can be best described as a
_______________ exchange rate system. (flexible/fixed
/managed floating).

Answer 8
managed floating

Question 9
Why does the central bank need to intervene in a
managed floating system?
(a) To reduce fluctuations in the exchange rate.
(b) To maintain the exchange rate at the specified level.
(c) To cover the surplus and deficits in the BoP.

Answer 9
(a) To reduce fluctuations in the exchange rate.

Question 10
Managed floating exchange rate system is a mixture of a
flexible exchange rate system and a fixed rate system.

Answer 10
True: Under managed floating exchange rate system, the
exchange rate is determined by the market forces of
demand and supply of foreign exchange (the float part)
but the central banks need to intervene to buy and sell
foreign currencies in an attempt to moderate exchange
rate movements whenever they feel that such actions are
appropriate (the managed part).

Question 11
If there is a deficit in the BoP, governments will have to
intervene to take care of the gap by use of its official
reserves. Which of the following exchange rate system
has been described above?
(a) Flexible exchange rate system
(b) Fixed exchange rate system
(c) Managed floating exchange rate system
(d) Both (b) and (c)

Answer 11
(d) Both (b) and (c)

Question 12
_____________ (Fixed/Floating) exchange rates system
automatically takes care of the surplus and deficits in the
BoP.

Answer 12
Floating

Question 13
In a ____________ the central banks do not intervene
in the foreign exchange market.
(a) Completely flexible exchange rate system, i.e. clean
floating
(b) Fixed exchange rate system
(d) Managed floating exchange

Answer 13
(a) Completely flexible exchange rate system, i.e. clean
floating

Question 14
In a fixed exchange rate system, when some government
action increases the exchange rate, it is called _________.
(a) Depreciation
(b) Appreciation
(c) Devaluation
(d) Revaluation

Answer 14
(c) Devaluation

Question 15
__________ is said to occur, when the Government
decreases the exchange rate in a fixed exchange rate
system.
(a) Depreciation
(b) Appreciation
(c) Devaluation
(d) Revaluation

Answer 15
(d) Revaluation

Question 16
Suppose the market determined exchange rate is `70/$.
However, the Indian Government fixes a higher exchange
rate of `75/$ for some reason. The is called ________ of
Rupee. The purpose of the Indian Government may be
___________.

Answer 16
Devaluation, to encourage domestic exports to US for
which it needs to make rupee cheaper for foreigners.

Question 17
The market determined exchange rate is `65/$. However,
to encourage exports the RBI devalued rupee by fixing a
higher exchange rate `75/$. How will the RBI intervene
to maintain the fixed exchange rate of `75/$?
(a) The RBI will withdraw dollars from its past holdings
of dollars to meet the excess demand for dollars in
the foreign exchange market.
(b) The RBI will purchase the dollars for rupees in the
foreign exchange market in order to absorb the
excess supply of dollars
(c) The RBI will follow the managed floating exchanges
rate system
Answer 17
(b) The RBI will purchase the dollars for rupees in the
foreign exchange market in order to absorb the
excess supply of dollars

Question 18
When the market determined exchange rate is higher
than the exchange rate fixed by the government there
will be ___________ (excess demand/ excess supply) of
foreign exchange in market. The government will ______
(buy/sell) foreign exchange from its resources. If it fails to
do so, a black market for foreign exchange may come up.
When people know that the amount of reserves is
inadequate, they would begin to doubt the ability of the
government to maintain the fixed exchange rate. This may
give rise to _____________. When this belief translates
into aggressive buying of one currency thereby forcing
the government to devalue, it is said to constitute a
speculative attack on a currency.
Answer 18
(i) excess demand
(ii) sell
(iii) Speculation of devaluation

Question 19
Excess demand of foreign exchange implies there is ____
in the BOP. Thus, the Central Bank will have to intervene
to take care of the gap by ______________.

Answer 19
(i) deficit
(ii) use of its official reserves of foreign exchange

Question 20
__________ (Fixed/Flexible) exchange rate system gives
the government more flexibility and they do not need to
maintain large stock of foreign exchange reserves.

Answer 20
Flexible

Question 21
The flexible exchange rate system is also called ________
because exchange rate movements automatically take care
of the surpluses and deficits in the BOP. The Central Banks
do not have to intervene to maintain exchange rate which
are automatically taken care of by the market.
On the other hand, the managed floating exchange rate
system is also called ____________ as central banks
intervene to buy and sell foreign currencies to moderate
exchange rate movements in the foreign exchange market.

Answer 21
(i) Clean floating
(ii) Dirty Floating

Question 22
Which of the following is a source of supply of foreign
currency?
(a) Investments made abroad
(b) Loans and grants from abroad
(c) Imports of goods and services
(d) Tourists going abroad

Answer 22
(b) Loans and grants from abroad

Question 23
State giving reason, whether the following
The official reserve transactions are relevant under
fixed exchange rate system.

Answer 23
True: Under fixed/pegged exchange rate system, the
Central Bank actively uses its foreign exchange reserves
to maintain the officially determined exchange rate. Thus,
the official reserve transactions are relevant under a
regime of pegged or fixed exchange rates.

Question 24
Price of one currency in relation to foreign currencies is
determined by forces of demand and supply is known as:
(a) Equilibrium Rate
(b) Fixed exchange Rate
(c) Exchange Rate
(d) Flexible exchange Rate

Answer 24
(d) Flexible exchange Rate

Question 25
Occasional intervention by the central bank to influence
the exchange rate is known as:
(a) Managed floating
(b) Hedging
(c) Appreciation
(d) Depreciation

Answer 25
(a) Managed floating

Question 26
Which of the following is a source of supply of foreign
exchange?
(a) Current transfers to abroad
(b) Speculation
(c) Portfolio investment
(d) None of these

Answer 26
(c) Portfolio investment

Question 27
The component of demand for foreign exchange are:
(a) Repayment of international debts
(b) Imports
(c) Exports
(d) Remittances from abroad

Answer 27
(b) Imports

Exchange Rate in a Free Market:
5.3 Effects of Change in Demand and
Supply
Effects of Increase in Demand for Foreign
Exchange
Increase in demand for foreign exchange may be due
to the following reasons:
(i) Rise in imports of foreign goods and services, for
example, due to increased international travelling
by Indians,
(ii) Purchasing more financial assets abroad,
(iii) Increase in demand for foreign exchange for
speculative purposes,
(iv) Increase in transfer payments to foreign countries,
etc.
Effect on the exchange rate
 Due to increase in demand for foreign exchange, the
demand curve shirts upward and right to the original
demand curve.
 Supply of foreign exchange remaining same, increase
in demand will cause excess demand of foreign
currency at the prevailing foreign exchange rate.
 As a result, a new equilibrium rate of foreign exchange
rate will be determined which will be higher than the
prevailing foreign exchange rate.
 Thus, there will be a rise in the foreign exchange rate
(say from `70/$ to `75/$), other things remaining
unchanged.
 Rise in the price of foreign exchange, say `70/$ to
`75/$ implies ‘depreciation’ of domestic currency
(rupees).
Depreciation is the fall in the value of domestic currency
in relation to a foreign currency caused by rise in foreign
exchange rate in the foreign exchange market under the
flexible exchange rate system.
Depreciation of rupee indicates that the value of rupees
in terms of dollars has fallen. Clearly, a rise in exchange
rate from `70/$ to `75/$ means that we need to pay more
rupees for a dollar now.
Effect of depreciation of domestic currency
on exports and imports
Depreciation of domestic currency (rupees) normally
increases exports from a country, as exports become
cheaper for the foreign nationals and foreign currency
can now buy more of domestic goods, i.e., the international
competitiveness of the goods and services of the nation
gets better.
On the other hand, Depreciation of domestic currency
(rupees) will increase the cost (in terms of rupees) of
purchasing a foreign good. Indians will have to pay more
rupees to import foreign goods. This reduces demand for
imports of foreign goods. Thus, imports fall.
Effect on national income
Since exports rise and imports fall, therefore, Net Exports
(= Exports – Imports) will increase. An increase in Net
Exports will increase the national income, other things
remaining unchanged.
 Top Tips
1. Effects of decrease in demand for foreign exchange
Due to decrease in demand for foreign exchange, the demand curve
shifts leftwards to the original demand curve. Supply of foreign
exchange remaining same, decrease in demand will cause excess supply
of foreign currency at the prevailing foreign exchange rate. As a result, a
new equilibrium rate of foreign exchange rate will be determined which
will be lower than the prevailing foreign exchange rate. Thus, foreign
exchange rate is likely to fall, leading to appreciation of domestic
currency. (Appreciation will be discussed next.)
2. Depreciation of domestic currency implies appreciation of the foreign
currency.
Effects of Increase in Supply for Foreign
Exchange
Increase in supply for foreign exchange may be due to
the following reasons:
(i) Rise in exports of goods and services,
(ii) Increase in foreign investments(e.g. Foreign Direct
Investment, Portfolio Investments, etc.),
(iii) More foreign tourists coming to India, etc
Effect on the exchange rate
 Due to increase in supply of foreign exchange, the supply
curve shifts rightwards to the original supply curve.
 Demand for foreign exchange remaining same,
increase in supply will cause excess supply of foreign
currency at the prevailing foreign exchange rate.
 As a result, a new equilibrium rate of foreign exchange
rate will be determined which will be lower than the
 Thus, there will be a fall in the foreign exchange rate
(say from `70/$ to `68/$), other things remaining
unchanged.
 Fall in the price of foreign exchange, say `70/$ to `68/$
implies ‘appreciation’ of domestic currency (rupees).
In a flexible exchange rate system, when the price of
foreign currency (say, dollars) in terms of domestic
currency (rupees) falls, the value of domestic currency
in terms of foreign currency increases, it is called
appreciation of domestic currency.
Appreciation of domestic currency means that we need
to pay fewer rupees in exchange for one dollar.
For example, a fall in the exchange rate (say, from `70/$
to `68/$) indicates that the value of rupee relative to
dollar has increased since we need to pay only 68
rupees in exchange for one dollar.
Effect of appreciation of domestic currency
on exports and imports
Appreciation of domestic currency decreases exports
since domestic goods become costlier for the foreign
nationals. This is so because one unit of foreign currency
can now buy less of domestic goods, i.e. the international
competitiveness of the goods and services of the nation
gets worse.
On the other hand, due to appreciation of domestic
currency, the importers have now to pay less domestic
currency to import one unit worth of foreign currency
goods. Imports thus become cheaper. This raises demand
for imports.
Effect on national income
Since exports decrease and imports increase, therefore, Net
Exports (= Exports – Imports) will decrease. A decrease in
Net Exports will decrease the national income, other things
remaining unchanged.
 Top Tips
1. Effects of decrease in supply of foreign exchange
Due to decrease in supply of foreign exchange, the supply curve
shifts leftwards to the original supply curve. Demand for foreign
exchange remaining same, decrease in supply will cause excess
demand of foreign currency at the prevailing foreign exchange rate.
As a result, a new equilibrium rate of foreign exchange rate will be
determined which will be higher than the prevailing foreign exchange
rate. Thus, foreign exchange rate is likely to rise, leading to depreciation
of domestic currency.
2. Appreciation of domestic currency implies depreciation of foreign
currency.
Key Terms
Depreciation of domestic currency – Depreciation is the fall in

the value of domestic currency in relation to a foreign currency
caused by rise in foreign exchange rate in the foreign exchange
market under the flexible exchange rate system.
Appreciation of domestic currency – In a flexible exchange
rate system, when the price of foreign currency (say, dollars) in
terms of domestic currency (rupees) falls, the value of
domestic currency in terms of foreign currency increases, it is
called appreciation of domestic currency.
RECAP
Depreciation of domestic currency

It means fall in the value of domestic currency in terms of a foreign
currency caused by a rise in the exchange rate under the flexible
exchange rate system.
 Depreciation of home currency implies fall in the purchasing
power of domestic currency in terms of foreign currency.
 Depreciation of home currency implies fall in the price of
domestic goods for the foreign buyers.
Depreciation encourages exports as domestic goods become
cheaper for the foreign nationals, i.e., the international competitiveness
of the goods of the nation gets better.
However, depreciation will make imports of foreign goods costlier.
So, imports fall.
Since exports rise and imports fall, therefore, Net Exports (Exports
– Imports) will increase.
Therefore, national income is likely to rise.
Appreciation of domestic currency
It means a rise in the value of domestic currency in terms of a
foreign currency caused by a fall in the exchange rate under the
flexible exchange rate system.
 Appreciation of home currency implies that purchasing
power of home currency in terms of a foreign currency has
gone up.
 Appreciation makes foreign goods cheaper for the domestic
buyer.
Appreciation decreases exports since domestic goods become
costlier for the foreign nationals.
However, it will make imports cheaper for the Indian residents
since they have to pay less domestic currency to buy imported
goods. So, imports rise.
Since exports fall and imports rise, therefore, Net Exports
(Exports – Imports) will decrease.
Therefore, national income is likely to fall.
Question 1
A rise in price of foreign exchange will increase demand
for imports.

Answer 1
False: A rise in price of foreign exchange will increase
the cost (in terms of rupees) of purchasing a foreign
good. This reduces demand for imports,; other things
remaining constant.

Question 2
A rise in price of foreign exchange increases India’s
exports.

Answer 2
True: A rise in price of foreign exchange will reduce
the foreigner’s cost (in terms of USD) while purchasing
products from India other things remaining constant
this increase India’s exports.

Question 3
What will be the likely effects of increased international
travelling by Indians?
(a) Depreciation of Rupee
(b) Increase in exports
(d) Increase in imports

Answer 3

Question 4
In a flexible exchange rate regime, when the price of
domestic currency (rupees) in terms of foreign currency
(Dollars) decrease, it is called _____________ of the
domestic currency (rupees) in terms of foreign currency
(dollars).
(a) Depreciation
(b) Appreciation
(c) Devaluation
(d) Revaluation
Answer 4
(b) Appreciation

Question 5
Suppose the Rupee-Dollar exchange rate is `70/$. Indian
investors believe that USD is going to appreciate by the
end of the month and will be worth `75. The investors
think if they gave the dealer `70,000 and bought 1,000
dollars, at the end of the month, they would be able to
exchange the dollars for `75,000, thus making a profit of
`5,000.
What will be the likely effect of this speculation or
expectation on the exchange rate in the present?

(a) The exchange rate will increase.
(b) The exchange rate will decrease.
(c) The exchange rate will remain unchanged.
(d) None of the above.

Answer 5
(a) The exchange rate will increase.

Question 6
A rise in the interest rates at home leads to ________
of the domestic currency. (depreciation/appreciation)

Answer 6
appreciation

Question 7
It government bonds in country A pay 8 per cent of
interest whereas equally safe bonds in country B yield
10 percent, what will be the likely effect on country A’s
currency?
(a) Depreciation
(b) Appreciation
(c) Devaluation
(d) No effect

Answer 7
(a) Depreciation
Hint: Due to interest rate differential of 2 per cent,
investors from country A will be attracted by the high
interest rates in country B and will buy the currency
of country B selling their own currency to make
investment in country B. So, demand for currency of
country B increases, causing depreciation of currency
of country A.

Question 8
If there is increase in income in the home country, the
domestic currency will be ___________. (depreciating
/appreciating)

Answer 8
Depreciating
Hint: When income increases, consumers spending
increases. Spending on imported goods is also likely to
increase. When imports increase, the demand for foreign
exchange increases. The exchange rate thus, is likely to
rise.There is a depreciation of the domestic currency.

Question 9
If there is an increase in income abroad the domestic
currency will be ________________. (depreciating/
appreciating)

Answer 9
appreciating
Hint: Due to an increases in income abroad, domestic
exports will rise and hence the supply of foreign
currency will increase. The exchange rate is likely to fall.
There is appreciation of domestic currency.

Question 10
If income increases in the home country as well as
abroad, what is the likely effect on the value of domestic
currency.
(a) Domestic currency will be depreciating
(b) Domestic currency will be appreciating
(c) Domestic currency may be depreciating or
appreciating

Answer 10
(c) Domestic currency may be depreciating or appreciating
Hint: with increase in income, demand for imported
goods and hence demand for foreign exchange increases.
With increase in income abroad as well, domestic exports
and hence supply of foreign exchange also increase.
On balance, the domestic currency may be depreciating
or appreciating
– If imports are growing faster than exports, domestic
currency will be depreciating
– If exports are growing faster than imports, domestic
currency will be appreciating
Question 11
Suppose a shirt costs $20 in the US and `1000 in India,
What will be the effect on exports of India if the
rupee-dollar exchange rate is `70/$?
(a) Exports will increase
(b) Exports will decrease
(c) Exports will remain unchanged

Answer 11
(a) Exports will increase
Hint: At the exchange rate `70/$, it costs `1,400 (=
`20) in the US but only `1,000 in India. Being cheaper,
exports of shirts from India will increase.

Question 12
Other things remaining unchanged when in a country
the price of domestic currency rises, national income
is:
(a) Likely to rise
(b) Likely to fall
(c) Not affected
(d) Likely to rise and fall both

Answer 12
(b) Likely to fall
Reason: When the price of domestic currency rises, it
denotes appreciation of domestic currency. So, imports
will rise and exports will fall, i.e. net exports will fall. So,
aggregate demand and hence national income will fall,
other things remaining unchanged.

Question 13
Suppose the present foreign exchange rate is of `70/$. It
rises to `75/$ leading to rise in prices of imports of
essential goods. How can the RBI help in bringing down
the foreign exchange rate which is very high?
(a) The RBI should withdraw dollars to sell them in the
(b) The RBI should purchase the dollars for rupees in
the foreign exchange market.
(c) The RBI should fix the exchange rate at lower level.
Answer 13
(a) The RBI should withdraw dollars to sell them in the
Hint: Selling dollars will cause increase in supply of
dollars in the foreign exchange market. It will lead
to a fall in the exchange rate.

Question 14
A fall in the external value of a currency as notified by the
government of the country is called _______________,
whereas a fall in the external value of a currency due to
the change in demand and supply of the currency in the
foreign exchange market is called _______________.

Answer 14
(i) Devaluation of currency
(ii) Depreciation of currency

Question 15
“Indian rupee (`) plunged to all time low of `74.48 against
the US Dollar ($).” What will be effect on National
Income of India, other things remaining the same?
(i) National Income will rise.
(ii) National Income will fall.
(ii) National Income may or may not fall.
(iv) National Income may or may not rise.

Answer 15
(i) National Income will rise.
Hint: Depreciation of Rupee will encourage exports
while discourage imports. Net exports (= Exports -
Imports) will increase. Hence, national income will rise,
other things remaining the same.

Question 16
“USA has accused China of currency devaluation to
promote its exports.” Is it true that by devaluating its
currency, China can promote its exports?

Answer 16
True: Devaluation of currency makes Chinese goods
cheaper in the international market. Thus, it promotes
exports of Chinese goods and may adversely impact the
production and sale of importing country.(USA)

Question 17
What is the likely impact of foreign exchange speculation
on the exchange rate?
(a) Exchange rate is likely to fall
(b) Exchange rate is likely to rise
(c) Exchange rate remains unchanged
(d) None of these

Answer 17
(b) Exchange rate is likely to rise

Question 18
Which of the following is likely to raise the foreign
exchange rate?
(a) Government gives incentives for exports.
(b) Government doubled the import duty on gold.
(c) Government promotes foreign direct investment.
(d) Visits to foreign countries by people increase.

Answer 18
(d) Visits to foreign countries by people increase.

Question 19
A rise in the interest rates at home leads to ________.
(a) Depreciation of foreign currency
(b) Depreciation of domestic currency
(c) Rise in exchange rate
(d) None of these

Answer 19
(a) Depreciation of foreign currency

Question 20
Other things remaining the same, when in a country
the price of foreign currency rises, national income is
likely:
(a) to rise
(b) to fall
(c) to rise or to fall
(d) to remain unaffected

Answer 20
(a) to rise

Question 21
An increase in demand for imported goods raises the
foreign exchange rate.
(True/False)

Answer 21
True: Demand for foreign exchange will increase in
order to make the payment for imported goods. Supply
of foreign exchange remaining unchanged, increase in
demand will cause the exchange rate to rise.

Question 22
How can increase in foreign direct investment, other
things remaining the same affect the foreign exchange
rate:
(a) Exchange rate will fall
(b) Exchange rate will rise
(c) No change in exchange rate
(d) None of these

Answer 22
(a) Exchange rate will fall

Question 23
When the exchange rate rises under managed floating,
it is called ______________ of domestic currency.
(a) Devaluation
(b) Appreciation
(c) Depreciation
(d) Revaluation

Answer 23
(c) Depreciation

Question 24
When there is depreciation of foreign currency, the supply
of foreign currency in domestic economy will:
(a) Increase
(b) Not change
(c) Either increase or decrease
(d) Decrease

Answer 24
(d) Decrease

Question 1
What is the role of a Central Bank in the following
exchange rate?
(CBSE Sample Question Paper 2015) (3 marks)
(a) Fixed exchange
(b) Floating exchange
(c) Managed floating

Answer 1
The role of the Central Bank in maintaining the foreign
exchange rates under different regimes is:
(a) Fixed exchange rate system: A Central Bank
actively uses its foreign currency reserves to
maintain the officially determined exchange rate
(b) Floating exchange rate system: A Central
Bank does not maintain any reserves of foreign
currency as the market automatically adjusts to
determine the market driven exchange rate

(c) Managed Floating: A Central Bank enters the
foreign exchange market to buy/sell foreign currency
in order to control fluctuations and volatility in the
market.

Question 2
‘Devaluation and Depreciation of currency are one and
the same thing’. Do you agree? How do they affect the
exports of a country?

Answer 2
Depreciation and Devaluation both imply a fall in external
value of a currency; however the term depreciation is used
under the floating exchange rate system that is when the
exchange rate system is determined by the combined
market forces of demand and supply. A currency loses or
gains value because of fluctuations in demand and supply.
The term devaluation is used in system of fixed exchange
rates. In this system, the exchange value of a currency is
decided by the government. Devaluation of currency is the
deliberate value of currency decided by the government.
Devaluation of currency is the deliberate action of the
government.
Depreciation and devaluation of a currency normally
encourages exports from a country, as exports become
cheaper for the foreign nationals and foreign currency can
now buy more of domestic goods, i.e., the international
competitiveness of the goods and services of such a
nation gets better.

Question 3
“Foreign Institutional Investors (FIIs) remained net seller
in the Indian capital markets over the last few weeks.”
– The Economic Times
State and discuss the likely effects of the given statement
on foreign exchange rate with reference to the Indian
Economy.

Answer 3
Selling of securities by Foreign Institutional Investors
(FII’s) in Indian capital market will lead to fall in the
supply of foreign currency in the economy. This situation
might lead to excess demand of foreign currency at the
As a result, a new equilibrium rate of foreign exchange
will be determined which will be higher than the
prevailing foreign exchange rate, leading to depreciation

Question 4
"Many large Multinational Corporations (MNCs) have
recently shifted their investments from China and have
started their production in India, thereby boosting the
Make in India plans of the Government." Presuming
other factors being constant, discuss the effects of the
given statement on Foreign Exchange rates with
reference to the Indian Economy.

Answer 4
Investments by large multinational corporations (MNCs)
in India will ensure greater inflow of foreign exchange,
leading to an increase in the supply of foreign currency.
This situation may result into excess supply of foreign
currency in the economy at the prevailing foreign
exchange rate.
As a result, a new equilibrium rate of foreign exchange
will be determined which will be lower than the
prevailing foreign exchange rate, leading to appreciation

Question 5
‘‘Indian rupee (`) plunged to all time low of `74.48
against the US Dollar ($)’’. –The Economic Times
In the light of the above report, discuss the impact of the
situation on Indian Imports, Exports and BoP position of
India.
(4 marks)

Answer 5
Indian rupee plunged to all time low of `74.48 against US
dollar. It is called depreciation in the value of Indian Rupees.
It may lead to fall in imports as foreign goods will become
costlier for the domestic consumers. Fall in imports less
outflow of foreign exchange from the country.
Also, depreciation of rupee causes increase in exports of
India since international competitiveness of Indian goods
gets better. So, there will be more inflow of foreign
exchange into the country. Thus, net inflow of foreign
exchange increases which has favourable effect on the
Balance of Payments position.
Question 6
“Government of India doubled the import duty on gold.”
Economy.
(4 marks)

Answer 6
Increasing import duty on gold will make imports of gold
costly. It will reduce demand for import of gold and
consequently of foreign exchange. This situation may result
into excess supply of foreign currency in the economy at
the prevailing foreign exchange rate.
As a result, a new equilibrium rate of foreign exchange will
be determined which will be lower than the prevailing
foreign exchange rate, leading to appreciation of domestic
currency.
Thus, foreign exchange rate is likely to fall.

Question 7
“Visits to foreign countries for sightseeing etc. by the
people of India is on the rise.”
Presuming other factors being constant, discuss the effects
of the given statement on Foreign Exchange rates with
reference to the Indian Economy.
(4 marks)

Answer 7
It will raise demand for foreign exchange for spending the
same in foreign countries. This situation might lead to
excess demand of foreign currency at the prevailing
foreign exchange rate. As a result, a new equilibrium rate
of foreign exchange will be determined which will be
higher than the prevailing foreign exchange rate, leading to
depreciation of domestic currency. Thus, foreign exchange
rate likely to rise.

Question 8
“Government of India is giving incentives for exports.”
Economy.
(4 marks)

Answer 8
Incentives for exports are aimed at increasing exports.
Increase in exports will bring more foreign exchange into
the country (i.e. increase in supply of foreign exchange).
This situation may result into excess supply of foreign
currency in the economy at the prevailing foreign exchange
rate.
As a result, a new equilibrium rate of foreign exchange will
be determined which will be lower than the prevailing
foreign exchange rate, leading to appreciation of domestic
currency.
Thus, foreign exchange rate is likely to fall.
Question 9
Suppose the present foreign exchange rate is 1 $= `70. It
rises to 1 $ = `74 leading to rise in prices of imports of
essential goods. How can Reserve Bank of India help in
bringing down the foreign exchange rate which is very
high?

Answer 9
Rise in exchange rate from 1 $ = `70 to 1 $ = `74 means
depreciation of Indian currency. Foreign goods become
costlier. Prices of imports of essential goods rise. So,
imports decrease. The Reserve Bank of India should sell
US Dollars from its foreign exchange reserves. As a result,
supply of foreign exchange (dollars) in the foreign
exchange market increases. It will lead to fall in the foreign
exchange rate.

Question 10
How can increase in foreign direct investment affect the
price of foreign exchange and exports? (4 marks)

Answer 10
Foreign direct investment (FDI) is a source of supply of
foreign exchange as it brings in foreign exchange into the
country. Supply of foreign exchange will increase in the
market. This situation may result into excess supply of
foreign currency in the economy at the prevailing foreign
exchange rate. As a result, a new equilibrium rate of
foreign exchange will be determined which will be lower
than the prevailing foreign exchange rate, leading to
appreciation of domestic currency. Thus, foreign exchange
rate is likely to fall.
Fall in exchange rate means that exports become costlier
for the foreign buyers because they will now get less
goods and services for each unit of foreign currency. This
will reduce exports from India.

Question 11
According to recent media reports: ‘USA has accused
China of currency devaluation to promote its exports’.
In the light of the given media report comment, how
exports can be promoted through the Currency
devaluation?
(CBSE SQP 2019) (3 marks)

Answer 11
USA has a valid point of argument as devaluation of a
currency encourages exports of a country. As exported
goods become cheaper in the international market
giving a competitive edge for the goods of domestic
country (China).
Devaluation of the value of domestic currency
promotes the exports of the country and may
adversely impact the production and sale of importing
country (USA).

Question 12
Indian investors lend abroad. Answer the following
questions:
(a) In which sub-account and on which side of the
Balance of Payments such lending is recorded?
Give reasons.
(b) Explain the impact of this lending on foreign
exchange rate.
(4 marks)

Answer 12
(a) Indians lending abroad is recorded in capital account
of the Balance of Payments because it is an
international transaction of assets. It is recorded on
the debit side because it leads to outflow of foreign
exchange.
(b) Lending abroad increases demand for foreign exchange.
Supply of foreign exchange remaining unchanged, the
exchange rate may rise.

Question 13
If USA has higher rate of inflation than in India, US
dollar will be depreciating. Do you agree with the given
statement? Support your answer with an example.
(3 marks)

Answer 13
Yes, the given statement is true.
Example: Suppose a shirt costs $10 in the US and ` 700
in India, the rupee-dollar exchange rate should be ` 70/$.
Suppose prices in India rise by 20 per cent while prices in
the US rise by 50 per cent. Indian shirts would now cost
`840 per shirt while American shirts cost $15 per shirt.
For these two prices to be equivalent, $15 must be
worth `840, or one dollar must be worth ` 56 (840/15).
The dollar, therefore, has depreciated since USA has
higher rate of inflation.

Question 14
Explain the effect of rise in income at home on the
foreign exchange rate.
(4 marks)

Answer 14
When income of people of India increases, consumer
spending increases. Spending on imported goods is also
likely to increase. When imports increase, the demand for
foreign exchange rises. This situation might lead to
excess demand of foreign currency at the prevailing
foreign exchange rate. As a result, a new equilibrium rate
of foreign exchange will be determined which will be
higher than the prevailing foreign exchange rate, leading
to depreciation of domestic currency. Thus, foreign
exchange rate likely to rise.

Question 15
Explain the impact of rise in exchange rate on national
income.

Answer 15
A rise in exchange rate, say rupee-dollar exchange rate
rises from `70/$ to `75/$, denotes depreciation of Indian
Currency (rupee). Indian goods will become cheaper to
foreigners because they can now buy more goods with
one unit of foreign currency (dollars). Exports become
cheaper. So, exports will increase.
On the contrary, our imports become costlier because
importers have to pay more rupees to buy one unit of
foreign currency worth goods. So, imports will decrease.
As a result, net exports (i.e., exports – imports) will
increase. Since net exports is a component of aggregate
demand, therefore, aggregate demand will increase [AD =
C + I + G + (X – M)]. Increase in aggregate demand will
increase the national income.

Question 16
How does foreign exchange speculation affect the
exchange rate? Explain with an example.
(3 marks)

Answer 16
Foreign exchange rate is affected by foreign exchange
speculation where foreign exchange is demanded for the
possible gains from appreciation of foreign currency.
Suppose the investors believe that the Rupee-Dollar
exchange rate is going to rise from `70/$ to `75/$ by the
end of the month. They think if they took `70000 and
bought 1000 dollars, at the end of the month they would
be able to exchange the dollars for `75000, thus making a
profit of `5000. This expectation would increase the
demand for dollars. Supply of foreign exchange remaining
unchanged, increase in demand will cause the exchange
rate to rise in the present.
Question 17
What is the effect of rise in interest rates at home on the
foreign exchange rate? Explain.
(3 marks)

Answer 17
A rise in interest rates at home will attract foreign
investors to invest in the home country. This will lead to
inflow of more foreign currency (i.e. increase in supply
of foreign exchange).
Demand of the foreign exchange remaining unchanged,
the exchange rate is likely to fall causing appreciation of
the domestic currency and depreciation of the foreign
currency.

Question 18
Suppose a shirt costs $10 in the US and `600 in India,
what will be the effect on exports of India if the rupee-
dollar exchange rate is `70/$?
(3 marks)

Answer 18
At the exchange rate `70/$, it costs `700 per shirt in
the US but only `600 in India. That is, international
competitiveness of shirts reduced in India gets better. In
that case, all foreign customers would buy shirts from
India.Thus, exports of shirts from India will increase.

Question 19
Explain the effect of rise in income on the exchange rate.
(6 marks)

Answer 19
When income of people of India increases, consumer
spending increases. Spending on imported goods is also
likely to increase. When imports increase, the demand for
foreign exchange rises. Supply of foreign exchange
remaining unchanged, the exchange rate is likely to rise.
There is a depreciation of the domestic currency.
If there is an increase in income abroad as well, domestic
exports will rise, i.e. more inflow of foreign exchange.
Therefore, supply of foreign exchange also increases. On
balance, the domestic currency may or may not
depreciate. What happens will depend on whether exports
are growing faster than imports. If exports are growing
faster than imports, domestic currency will appreciate.
On the other hand, if imports are growing faster, than
domestic currency will be depreciating.

Question 20
Explain the effect of difference in interest rates between
countries on the exchange rate with an example.
(6 marks)

Answer 20
In the short run, the interest rate differential i.e. the
difference between interest rates between countries is
an important factor in determining exchange rate
movements. For example, if government bonds in
country A pay 8 per cent rate of interest whereas
equally safe bonds in county B yield 10 per cent, the
interest rate differential is 2 per cent. Investors from
country A will be attracted by the higher interest rates
in country B and will buy the currency of country B
selling their own currency. At the same time investors
in country B will also find investing in their own country
more attractive and will therefore demand less of country
A’s currency. This means that the demand for country A’s
currency will decrease and the supply will increase causing
a depreciation of country A’s currency and an appreciation
of country B’s currency. Thus, a rise in the interest rates at
home often leads to an appreciation of the domestic
currency, other things remaining the same, e.g. no
restrictions exist in buying bonds issued by foreign
governments.

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