Class 12 Macroeconomics NCERT Solutions & Important Questions (with PDF)|Economics Class 12 |

×

Author Note

Welcome to the ultimate revision guide! Here are 60 strictly curated questions for Class 12 Macroeconomics - Chapter 11 (Foreign Exchange Rate). Happy studying!

Chapter 11: Foreign Exchange Rate (Top 60 Q&A)

• What is Foreign Exchange?

  Ans: Foreign exchange refers to all currencies other than the domestic currency of a given country.

• Define Foreign Exchange Rate.

  Ans: It is the rate at which the currency of one country can be exchanged for the currency of another country.

• What is the Foreign Exchange Market?

  Ans: The market where the national currencies of various countries are traded and converted into one another.

• What are the three main functions of the foreign exchange market?

  Ans: Transfer function, Credit function, and Hedging function.

• Explain the 'Transfer Function'.

  Ans: It implies the transfer of purchasing power between countries, facilitating international trade.

• Explain the 'Credit Function'.

  Ans: It provides credit for foreign trade. Bills of exchange are generally used for international payments with a maturity period of 3 months.

• What is meant by the 'Hedging Function'?

  Ans: It refers to the protection against the risk of adverse variations in foreign exchange rates by locking in a future exchange rate.

• What is a Fixed Exchange Rate System?

  Ans: A system in which the exchange rate for a currency is officially fixed by the government or the central bank.

• What is 'Pegging' in a fixed exchange rate?

  Ans: Pegging means tying the value of a domestic currency to a specific foreign currency or to gold to maintain a fixed rate.

• What is the Parity Value?

  Ans: The value of the domestic currency defined in terms of another currency or gold under the fixed exchange rate system.

• What is a Flexible (or Floating) Exchange Rate System?

  Ans: A system where the exchange rate is determined by the market forces of demand and supply of foreign exchange, without government intervention.

• What is another name for the Flexible Exchange Rate?

  Ans: It is also known as the Free Exchange Rate or Floating Exchange Rate.

• What is Managed Floating?

  Ans: A system where the exchange rate is determined by market forces, but the central bank intervenes occasionally to prevent extreme fluctuations.

• Why is managed floating called 'Dirty Floating'?

  Ans: Because it is a hybrid of flexible and fixed systems, and the central bank unofficially manipulates the market to influence the rate.

• What is Depreciation of domestic currency?

  Ans: A fall in the value of the domestic currency relative to foreign currency under a flexible exchange rate system.

• Give an example of Depreciation.

  Ans: If earlier $1 = ₹70 and now $1 = ₹80, the Indian Rupee has depreciated.

• What is Appreciation of domestic currency?

  Ans: A rise in the value of the domestic currency relative to foreign currency under a flexible exchange rate system.

• Give an example of Appreciation.

  Ans: If earlier $1 = ₹80 and now $1 = ₹70, the Indian Rupee has appreciated.

• What is Devaluation?

  Ans: A deliberate reduction in the value of the domestic currency by the government under a fixed exchange rate system.

• What is Revaluation?

  Ans: A deliberate increase in the value of the domestic currency by the government under a fixed exchange rate system.

• Differentiate between Depreciation and Devaluation.

  Ans: Depreciation occurs due to market forces in a flexible system, whereas devaluation is officially done by the government in a fixed system.

• Differentiate between Appreciation and Revaluation.

  Ans: Appreciation happens automatically via demand and supply, while revaluation is an official government action.

• Why do people demand foreign exchange? (Give two reasons)

  Ans: 1) To import goods and services. 2) To invest in foreign countries.

• Name two more sources of demand for foreign exchange.

  Ans: 1) To send unilateral transfers (gifts) abroad. 2) For tourism abroad.

• Why is the demand curve for foreign exchange downward sloping?

  Ans: There is an inverse relationship between the exchange rate and the demand for foreign exchange. When the exchange rate falls, foreign goods become cheaper, increasing imports and the demand for foreign currency.

• What are the sources of supply of foreign exchange? (Give two reasons)

  Ans: 1) Exports of goods and services. 2) Foreign Direct Investment (FDI) into the domestic country.

• Name two more sources of supply of foreign exchange.

  Ans: 1) Remittances by non-residents (gifts/grants from abroad). 2) Speculative purchases by foreigners.

• Why is the supply curve of foreign exchange upward sloping?

  Ans: There is a direct relationship between the exchange rate and supply. When the exchange rate rises, domestic goods become cheaper for foreigners, increasing exports and thus the supply of foreign exchange.

• How is the equilibrium exchange rate determined?

  Ans: It is determined at the point where the market demand for foreign exchange equals the market supply of foreign exchange.

• What is the Par Rate of Exchange?

  Ans: It is another term for the equilibrium exchange rate, where demand and supply curves intersect.

• What happens to the exchange rate when demand for foreign currency increases?

  Ans: An increase in demand (with constant supply) leads to a rise in the exchange rate, causing domestic currency depreciation.

• What happens when the demand for foreign currency decreases?

  Ans: A decrease in demand leads to a fall in the exchange rate, causing domestic currency appreciation.

• What happens when the supply of foreign currency increases?

  Ans: An increase in supply (with constant demand) lowers the exchange rate, resulting in the appreciation of the domestic currency.

• What happens when the supply of foreign currency decreases?

  Ans: A decrease in supply raises the exchange rate, resulting in the depreciation of the domestic currency.

• How does currency depreciation affect exports?

  Ans: Depreciation makes domestic goods cheaper for foreign buyers, leading to an increase in exports.

• How does currency depreciation affect imports?

  Ans: It makes foreign goods more expensive for domestic buyers, leading to a decrease in imports.

• How does currency appreciation affect exports?

  Ans: Appreciation makes domestic goods more expensive for foreigners, leading to a decrease in exports.

• How does currency appreciation affect imports?

  Ans: It makes foreign goods cheaper for domestic buyers, causing imports to increase.

• What is the Spot Market for foreign exchange?

  Ans: It is the market which handles current (on-the-spot) transactions of foreign exchange. The transactions are settled immediately.

• What is the Spot Rate of Exchange?

  Ans: The exchange rate that prevails at the time when current transactions take place in the spot market.

• What is the Forward Market?

  Ans: It is the market which handles transactions of foreign exchange meant for future delivery. Contracts are signed today, but delivery and payment happen on a specified future date.

• What is the Forward Rate of Exchange?

  Ans: The exchange rate agreed upon today for the exchange of currencies at some specific date in the future.

• Why do people participate in the forward market?

  Ans: Primarily for two reasons: Hedging (to avoid the risk of exchange rate fluctuations) and Speculation (to make a profit).

• What is Speculation in forex?

  Ans: Buying foreign currency when its price is low and selling it when the price is high, purely to earn a profit.

• What is meant by Foreign Direct Investment (FDI)?

  Ans: Investment made by a foreign entity that involves gaining ownership and control over an enterprise in the domestic country.

• What is the Gold Standard System of Exchange Rate?

  Ans: An old system (pre-1920s) where the value of every currency was defined in terms of a specific weight of gold.

• What was the Mint Par Value of Exchange?

  Ans: Under the gold standard, the exchange rate determined by the ratio of gold values of two different currencies.

• What was the Bretton Woods System?

  Ans: An adjustable peg system introduced in 1944 where currencies were pegged to the US Dollar, and the Dollar was pegged to Gold.

• Which institution maintained the Bretton Woods system?

  Ans: The International Monetary Fund (IMF).

• Why did the Bretton Woods system fail?

  Ans: It broke down in 1971 because the US could not maintain the dollar-to-gold convertibility due to massive trade deficits.

• Mention one merit of the Fixed Exchange Rate system.

  Ans: It ensures stability in the foreign exchange market, which encourages international trade and investment.

• Mention one demerit of the Fixed Exchange Rate system.

  Ans: The central bank must maintain massive reserves of foreign exchange to keep the rate fixed.

• Mention one merit of the Flexible Exchange Rate system.

  Ans: There is no need for the central bank to maintain large foreign exchange reserves.

• Mention one demerit of the Flexible Exchange Rate system.

  Ans: It causes uncertainty and instability in the market, making international trade riskier.

• How does an increase in national income affect the exchange rate?

  Ans: Higher income usually leads to higher imports, increasing the demand for foreign exchange and causing domestic currency to depreciate.

• If the US Federal Reserve raises interest rates, what happens to the Indian Rupee?

  Ans: Capital may flow out of India to the US for higher returns. This increases demand for Dollars, depreciating the Rupee.

• What is Arbitrage?

  Ans: The practice of buying a currency in one market where it is cheaper and simultaneously selling it in another market where it is dearer to make a risk-free profit.

• How do foreign tourists affect the forex market?

  Ans: Foreign tourists visiting the domestic country bring foreign exchange with them, increasing the supply of foreign currency.

• How do domestic tourists going abroad affect the forex market?

  Ans: They need foreign currency to spend abroad, which increases the demand for foreign exchange.

• When is an intervention by the Central Bank required in Managed Floating?

  Ans: When the exchange rate becomes too volatile or moves outside a target range, the central bank buys or sells foreign currency to stabilize it.