Worksheet Solutions: Open Economy Macroeconomics - 2 | Economics Class 12 - Commerce PDF Download

Q1: What is Balance of Payments?
Ans : It is a systematic record of all economic transactions between the residents of a country & rest of the world during a financial year. In other words, it is a summary record of all international economic transactions of a resident country with the rest of the world during a given period of time.

Q2: Define the term Balance of Trade.
Ans: It refers to the systematic record of visible items in a financial year. In other words, it is the value of imports and exports of commodities i.e. merchandise. If the exports exceed imports, the BOT is said to be favourable, and unfavourable in case of vice versa. Thus, Favourable BOT = Exports receipts > Import payments.

Q3: Differentiate between BOP & BOT.
Ans: The term ‘Balance of Payments’ refers to the account of both visible items & invisible items while ‘Balance of Trade’ refers to the record of visible items only. BOT is only one of the components of BOP while the BOP is a wider concept & therefore offers a more comprehensive picture of economic transactions of a country with the rest of the world. Moreover, the BOT may be balanced, deficit or surplus, while BOP as a whole always remain balanced. BOT is a simple statements related to the foreign trade of the country while BOP presents a classified record of all receipts on account of goods exported, services rendered and capital received, and payments made on account of goods imported, services rendered from, and capital transferred to abroad.

Q4: State the Items included in BOP account.
Ans : 

• Visible Items include all merchandise imports and exports i.e. the items which are recorded at the port & made of some material.
• Invisible Items include receipts & payments for the services viz. shipping, banking, insurance, travel etc.; receipts and payments of income on foreign investments; interest on foreign loans & remittances of NRI’s etc; govt’s current expenditure in abroad viz. expenditure on embassies etc.; transfer payments & receipts.
• Capital transfers include the capital receipts & capital expenditure of a resident country.

Q5: Explain the Structure of BOP: BOP account is categorized into Current Account & Capital Account.
Ans: BOP on Current Account refers to transactions related to goods, services, income on investments & unilateral transfers. BOP on current account reveals the net income of the country generated in abroad. Both visible & invisible items include constitute the current account of BOP. It need not always be in balance. It may show a surplus or deficit. It represents the difference between payments & receipts of currently produced & consumed goods & services. A deficit in current account indicates lowering down the level of income, creating problem of the payments to the foreigners & have adverse impact on country’s exchange reserves, & may increase external borrowings.
The components of BOP on current account are:

• Visible trade includes the export and import of the physical goods
• Invisible items include cost of non-factor services; investment income, & unilateral transfers.
  (i) The non-factor services include transportation, finance, tour & travel etc. The services rendered by the resident country to the ROW are recorded on the credit side, while the services rendered by the foreigners for the resident country are recorded on the debit side.
  (ii) Income on investment includes interest payments on foreign loans & credits, transfer of profits & miscellaneous for patents, royalties etc. The interest & dividend payments made by the foreigners are recorded on the credit side, and vice versa.
  (iii) Unilateral Payments includes foreign gifts & grants, donations, military aid, technical assistance etc. These are also referred to as unrequired transfers. These refer to those receipts or payments which take place without getting anything in return. These transfers are further classified into Official & Private transfer payments. Official unilateral transfers are the foreign donations & aids, while Private transfers refer to the gifts & donations from foreign residents to the domestic residents & vice versa. Payments of these transfers are recorded as debit & receipts are recorded as credit. Thus, the balance of visible trade, invisible trade & unilateral transfers is recorded as BOP on current account.
• BOP on Capital Account: It refers to the international transactions in financial assets viz. bonds, equities, loans, bank account etc.; fixed plants & equipment’s, and direct investments. It is a record of those transactions which leads to change in assets or liability of the resident country. In other words, it is record of capital transactions i.e. the private & the official capital transfers as well as the banking capital flows. BOP on capital account deals with payments of debts and claims. The components of BOP on capital account are:
  (i) Private Capital Transactions which refer to those transactions which affect assets or liabilities of the resident country.
  (ii) Official Capital Transactions refer to the transactions which affect assets & liabilities of the govt. It includes loans, repurchase & resale of securities sold to foreign residents, debt service, gold & foreign exchange reserves, & miscellaneous receipts & payments.
  (iii) Banking Capital Transactions includes movement in the external financial assets and liabilities of those banks which are authorized to deal in the foreign exchange.

Q6: Differentiate between BOP on current account & capital account.
Ans: The current account deals with the receipts & payments for those goods which are currently produced, while the capital account deals with debts & claims. Secondly, the BOP on current account has a direct influence on the level of income of a country, while the capital account influences the volume of assets of the country.

Q7: Briefly explain the other items in the BOP.
Ans: There are certain items which do not form the part of current & capital account. These items are kept for balancing the BOP. These items are as follows:
I. Errors & Omissions are the balancing items in the BOP accounts which are used for correcting the BOP as it is difficult to keep an accurate record of all the transactions which may be due to sample of transactions, dishonesty of traders, smuggling etc.
II. Official Reserve Transactions refer to those transactions which are carried out by the govt. and the Central bank on behalf of govt. with regard to certain economic policy & their effect on BOP, & the exchange rates. It includes the Country’s Official Reserve Assets & Foreign official Assets in the country.
The Official Reserves are held in the form of foreign currency or foreign securities, gold & Special Drawing Rights (SDR) with the IMF. Reduction in these reserves implies purchase of foreign exchange which is taken as credit items in the BOP since it causes inflow of foreign exchange. On the contrary, an increase in these reserve assets is taken as a debit in the BOP as it causes outflow of foreign exchange.
The Foreign Official assets in the country are in the form of rupee reserves of foreign central banks. Increase in these rupee reserves of foreign banks is taken as a credit item as it causes inflow of foreign exchange in the resident country (India), while decrease in these reserves is taken as debit as it causes outflow of foreign exchange.

Q8: Differentiate between Autonomous & Accommodating Items.
Ans: Items in the BOP account can be also classified into two categories viz. Autonomous or above the line items and Accommodating or below the line items.
Autonomous items refer to those items which are taken with the motive of profit maximization. These transactions are not related to the country’s BOP position. It is, therefore, these items are called as autonomous items. These items are taken as first items before calculating deficit or surplus in BOP account, therefore these items are called as above the line items. If the receipts from autonomous items exceed the payments for autonomous items; the BOP is called to be as surplus, and vice versa. It implies that the resident country has net claims against the ROW. On the other hand, if the payments for hese items exceed the receipts from these items, it implies that the ROW has some net claims against the resident country.
Accommodating items refer to those items which are undertaken by the govt. to keep the BOP balanced. These items are transacted when a country faces disequilibrium in the BOP. Through these transactions, the govt. or monetary authorities settle the deficit or surplus in the BOP.

Q9: What is meant by Disequilibrium in the BOP?
Ans: It refers to such a situation when the BOP of the country is deficit or surplus. In other words, it is a situation when the net balance of all receipts & payments is not zero. If the net balance is in (+), it is surplus; while the negative (-) balance is deficit. In both of the situation, the BOP is in disequilibrium.

Q10: State the causes for disequilibrium in BOP.
Ans: Disequilibrium in BOP may be due to the following reasons:
Economic Factors viz. Cyclical fluctuations, huge public expenditure on development projects, hike in inflation which induces large imports of essential goods, development of import substitutes, change in cost structure of the trading partner countries etc; Demonstration effect which implies the effect of developed countries on the lifestyle & consumption pattern of the less developed countries which leads to rise in imports; Political instability which may lead to large scale capital outflow; Social factors viz. changes in the social structure & norms which may affect the propensity to consume, comforts & exports; etc.

Q11: State the measures to correct adverse BOP:
Ans: Dear money policy, depreciation of the external value of domestic currency, devaluation of the currency, exchange control restrictions, tariff & import duties, fixing of import quotas, export promotion measures, import substitution etc.

Q12: Explain the determination of foreign Exchange Rate.
Ans: The exchange rate is the price of a currency in terms of another currency. It depends upon the different foreign exchange regimes which are Fixed Exchange Rate System & Flexible Exchange Rate System.
Fixed Exchange Rate System refers to the system in which the rate of exchange is determined by govt. or monetary authorities. It can be classified into Gold Standard System or Mint Parity of Exchange & Adjustable Peg System.
The fixed exchange rate system had certain merits viz. it ensured stability & fluctuations had been avoided; encouraged international trade due to low risk & lesser uncertainty & coordinated the macroeconomic policies across the different countries. But it had certain shortcomings viz. need of huge international reserves of gold; restriction in movement of capital due to the need of huge reserves of gold; discouraged venture capital; & rigid in resource allocation. Flexible Exchange Rate System refers to such a rate of exchange which is determined by the demand for & supply of the foreign exchange in the foreign exchange market. Under this system, the govt. or central bank does not intervene in the determination of exchange rates. The exchange rate is determined by the free play of two forces viz. demand & supply of concerned foreign currencies. The rate of exchange is determined when both demand & supply of foreign exchange are equal to each other.

Q13: State the sources of demand for foreign exchange.
Ans: These are import of goods & services; investment in other countries; gifts & grants to abroad; direct purchase made in abroad; other payments involved in international transactions etc. The demand for foreign exchange is made for the purpose of payments of foreign loans, import of products, making investments & giving loans to other countries, tour & travel in abroad etc. The demand for foreign exchange is inversely related to the exchange rate.

Q14: Differentiate between Depreciation and Devaluation.
Ans: Depreciation means decline in external value of a domestic currency in relation to a foreign currency, while the term devaluation also mean the same. But the difference is that depreciation takes place due to the outcome of changes in the market forces i.e increase in demand or decrease in supply of foreign exchange, while devaluation means a deliberate action taken by the Govt. in order to correct its deficit BOP by discouragingimports & encouraging exports which will increase the inflow & reduce the outflow of foreign exchange. Thus, depreciation is the part of flexible exchange rate system while devaluation is the part of fixed exchange rate system.

Q15: How do we finance the deficit on current account BOP in case officially reserves with the RBI are not moved?
Ans. We are left with on two alternatives only:1. We borrow from rest of the world; 2. We sell  our assets (financial assets like stock and bonds, and physical assets (like plant and machinery) to rest of the world.

Q16: What is depreciation of rupee? What is its likely impact on Indian imports and how?
Ans. Depreciation of rupee is the fall in the value of Indian currency in relation with foreign currency. More rupees are now required to buy a unit of foreign currency. This will make foreign goods expensive to the buyers in India. As a result, import are likely to fall.

Q17: How does decrease in FDI in India act as a supply stock for foreign exchange?
Ans: Decrease in FDI leads to a decrease in a supply of foreign exchange, for reasons other than change in exchange rate. It is a supply shock that cause a backward shift of supply curve of foreign exchange for the Indian economy. Consequently, equilibrium exchange will rise. More rupee are to be paid for buying a unit of foreign currency.

Q18: How do the deficit BoP and surplus BoP impact the exchange rate?
Ans. (i) Deficit Balance of Payment: If the balance of payment of a country show deficit, demand for foreign currency will increase. Accordingly, exchange rate is expected to rise. Domestic currency will depreciate in relation to foreign currency.
(ii) Surplus Balance of Payment: If the balance of payment of a country shows surplus, availability of foreign currency will increase. Accordingly, exchange rate is expected to fall. Domestic currency will appreciate in relation to foreign currency.

Q19: Define the term Foreign Exchange Rate.
Ans: It refers to the rate at which one unit of currency of a country is exchanged for the currency of other country. In other words, it is the price of one currency in terms of another currency.

Q20: Define the term Foreign Exchange Market.
Ans: It refers to the place where foreign currencies are bought & sold. It acts to transfer the purchasing power between the countries (transfer function); provides credit for international trade (credit function); make provision for hedging facilities i.e. protection against the risk related to variations in forex rate (hedging function).

Q21: How is depreciation of Indian rupee likely to affect Indian export? Explain.
Ans: Depreciation of the domestic currency implies that the domestic currency (rupee) loses its value in relation to foreign currency (say US Dollar). Now, more rupee are required to buy a dollar, or a dollar can now buy more goods in domestic in the domestic economy. Accordingly, exports are expected to rise.

Q22: Will you always appreciate a rise in exchange rate as a means to boost our exports?
Ans: No. Because a rise in exchange rate may not always lead to a rise in our export earnings. A rise in exchange rate is beneficial only elasticity of demand for our exports is greater than unity. Because, it is only then that the total expenditure on our exports will rise in response to a fall in prices of domestic goods (in terms of the foreign currency) yields greater revenue only when the elasticity of demand for our exports is greater than unity.

Q23: What are the Sources of Supply of foreign exchange?
Ans: These are the export of goods & services; investments by ROW in the resident country; receiving gifts, donations & grants from the ROW; remittances by the non-residents from the ROW; direct purchase made by the non-residents in the domestic country; other receipts involved in international transactions etc. The supply of foreign exchange is directly related to the exchange rate.

Q24: Explain the role of Central Bank during depreciation.
Ans: Due to depreciation, the price of imports rises due to which the price of essential products viz crude oil rises which leads to increase in petroleum prices & further which leads to inflation in the economy. The central Bank can resolve this under the managed floating system. The Central Bank will release more of dollars in the market & reduce the supply of INR. Consequently, the supply of dollars rises which leads to reduce its price, & on the other hand, the value of INR rises due to decline in availability. This process leads the exchange rate back to its original one later. Due to this act, the managed floating is also known as dirty floating.

Q25: Calculate the value of imports when the balance of trade is (-) Rs 800 crore and the value of exports is Rs 500 crore .
Ans: Balance of trade = Value of exports – Value of import; (-)800crore = 500 crore – value of import Value of imports = 500 crore + 800 crore; = Rs 1,300crore