Test: Open Economy Macroeconomics - 1 - UPSC MCQ

Exchange rates are defined as the price of one country's currency in relation to another country's currency.

The supply of foreign exchange comes through exports of goods and services.

Foreign exchange is an institution or system for dealing with the currencies of other countries.

The balance of payments (BOP) is the method by which countries measure all of the international monetary transactions within a certain period.

The source of demand for foreign exchange is Imports of goods and services from the rest of the world.

A trade deficit is an economic measure of international trade in which a country's imports exceeds its exports. A trade deficit represents an outflow of domestic currency to foreign markets. It is also referred to as a negative balance of trade (BOT).
Trade Deficit = Total Value of Imports – Total Value of Exports

A fixed or pegged rate is determined by the government through its central bank. The rate is set against another major world currency (such as the U.S. dollar, euro, or yen).

The flexible rate of exchange is the rate that is determined by the supply-demand forces in the foreign exchange market. 

The Flexible exchange rates can be defined as exchange rates determined by global supply and demand of currency. In other words, they are prices of foreign exchange determined by the market, that can rapidly change due to supply and demand, and are not pegged nor controlled by central banks.

Prevents Speculation in foreign exchange market: Another important merit of fixed exchange rate system is that it does away with speculation in foreign exchange markets. The advocates of fixed exchange rate system points out that the flexible and unstable exchange rate encourages speculation in foreign exchange market.