Short Answer Questions (with Solutions) - Open Economy Macroeconomics

Q1 Define foreign exchange rate.
Ans:  Foreign exchange rate is the price at which one country's currency can be exchanged for another country's currency. It shows how much of one currency is required to obtain a unit of another currency.
 

Q2 What do you mean by Foreign Exchange Market?
Ans:  The foreign exchange market is the market where international currencies are bought and sold. It brings together participants who trade currencies for purposes such as trade payments, investment and speculation, and it helps determine exchange rates.
 

Q3 What is meant by Fixed Exchange Rate?
 Ans:  A fixed exchange rate is a rate set and maintained by a country's government or central bank. The authority announces the rate and intervenes in the foreign exchange market to keep the currency at that level; only the authority can change it.
 

Q4 What is equilibrium rate of exchange?
 Ans:  The equilibrium exchange rate is the rate at which the supply of foreign exchange equals the demand for foreign exchange in the market. At this rate there is no tendency for the exchange rate to change.
 

Q5 Define flexible exchange rate.
Ans: A flexible exchange rate is one that is determined by market forces of demand and supply for different currencies in the foreign exchange market. It adjusts continuously in response to international transactions and capital flows.
 

Q6 What is meant by appreciation of currencies?
 Ans:  Appreciation of a currency occurs when its value rises relative to other currencies. As a result, fewer units of the domestic currency are needed to buy a unit of the foreign currency.
 

Q7 What is meant by balance of payments?
 Ans:  The balance of payments is a systematic record of all economic transactions between residents of a country and the rest of the world over a period of time. It includes trade in goods and services, income flows, and capital movements.
 

Q8 What do you mean by balance of trade?
 Ans:  Balance of trade is the difference between the value of a country's exports and imports of physical goods (visible items) over a given period.
 

Q9 The balance of trade shows a deficit of Rs. 600 crores, the value of exports is Rs.1000 crores.  What is value of Imports?
 Ans:  Balance of trade (B.O.T.) = Exports - Imports
Given B.O.T. = -600 and Exports = 1000
So, Imports = Exports - (B.O.T.)
= 1000 - (-600)
= Rs. 1,600 crores.
 

Q10 What is the balance of visible items in the balance of payments account called?
 Ans:- Balance of trade
 

Q11 What do you mean by disequilibrium in BOP?
 Ans:- Disequilibrium in the balance of payments means that receipts from the rest of the world are not equal to payments to the rest of the world; in other words, there is either a surplus or a deficit in the BOP account.
 

Q12 List two items of the capital account of BOP account.
Ans:- i) External assistance           
ii) Commercial borrowing       
iii) Foreign investment
 

Q13 Which transactions bring balance in the BOP account?
 Ans:- Accommodating transactions bring balance in the BOP account. These include actions such as changes in foreign exchange reserves, official borrowing or lending, and other financing measures taken to correct a surplus or deficit.
 

Q14 Define autonomous items in BOP.
 Ans:- Autonomous items in the BOP are international transactions carried out for their own economic motives, such as trade, investment or profit-seeking. They occur independently of the current state of the country's balance of payments.
 

Q15 What is the other name of autonomous items in the BOP?
 Ans:- The other name of autonomous items in the BOP is above-the-line items.
 

Q16 When does a situation of deficit in BOP arises?
 Ans:- A deficit in the BOP arises when autonomous receipts (inflows) are less than autonomous payments (outflows). In that case, accommodating transactions or official financing are required to cover the shortfall.
 

Q17 What is meant by managed floating?
 Ans:- Managed floating is a system in which the exchange rate is generally allowed to be determined by market forces but the central bank intervenes occasionally according to a set of declared rules or policy to smooth excessive volatility or correct misalignments.

Q18 Why is foreign exchange demanded?
Ans:- Foreign exchange is demanded for the following purposes:
a) Payment of international loans and interest due to non-residents.
b) Gifts and grants sent to persons or organisations in other countries.
c) Investment abroad, such as buying foreign assets or making direct investments.
d) Purchases from abroad - payments for imports of goods and services and payments by tourists travelling abroad.
 

Q19 What determines the flow of foreign exchange in to the country?
 Ans: - The flow of foreign exchange into a country is determined by:
a) Purchases of domestic goods and services by foreigners (exports).
b) Direct foreign investment and portfolio investment inflows into the home country.
c) Speculative purchases of domestic currency by foreigners expecting future gains.
d) Receipts from foreign tourists visiting the country.
 

Q20 Why does the demand for foreign exchange rise, when it price falls?
 Ans:-  When the price of foreign exchange falls (that is, the foreign currency becomes cheaper in terms of domestic currency), the domestic currency has appreciated. As a result:
- Imported goods and services become less expensive for domestic buyers, so imports rise.
- Overseas travel and purchases by residents become cheaper.
Both effects raise the quantity of foreign currency demanded. Thus there is an inverse relationship between the price of foreign exchange and its demand.
 

Q21 When price of a foreign currency falls, the supply of that foreign currency also fall why?
 Ans:  When the price of a foreign currency falls (domestic currency appreciates), domestic exporters receive fewer domestic currency units when they convert their foreign currency receipts. This reduces exporters' willingness to sell foreign currency for domestic currency, so the supply of foreign currency declines. Also, foreign investors may find domestic assets more expensive in their own currency, reducing capital inflows and further lowering supply of foreign currency.
 

Q22 Distinguish between autonomous and accommodating transaction of balance of payment account.
 Ans:  Autonomous transactions: These arise from normal economic motives such as trade, investment and profit maximisation; they occur independently of the BOP position.
Accommodating transactions: These are undertaken specifically to correct an imbalance in the BOP (deficit or surplus) and include official financing measures such as changes in reserves or borrowing from abroad.
 

Q23 Give two examples explain why there is a rise in demand for a foreign currency when its price falls.
Ans: When the price of a foreign currency falls:
• Imports become cheaper for domestic buyers; therefore importers need more foreign currency to pay for larger import volumes, raising demand for that currency.
• Foreign travel becomes less expensive for residents; more people travel abroad and demand more foreign currency for spending, raising demand further.
 

Q24 Distinguish between fixed and flexible foreign exchange rate.
Ans:  Fixed exchange rate: The rate is set and maintained by the central bank or government; the authority intervenes in the foreign exchange market to keep the rate stable.
Flexible exchange rate: The rate is determined by market forces of demand and supply; it fluctuates freely and adjusts to economic conditions.