NCERT Solutions for class 12th Economics Part B Chapter 6 Open Economy Macroeconomics

NCERT Questions Solved

Question 1. Differentiate between balance of trade and current account balance.

Ans. Balance of Trade: It is the difference between the value of exports and imports of material goods. It shows visible trade transactions.
BOT = Value of goods exported – Value of goods imported If value of goods exported is more the value of goods imported then it called favourable/positive BOT. Thus, BOT shows a surplus. In case the value of goods imported is more than value of goods exported then it is called unfavourable/adverse/negative BOT. Then BOT is called in deficit. If value of exports is equal to value of imports then BOT is said to be balanced or in equilibrium. It is a narrower concept as compared to BOP.

Current Account: The current account of BOP records transactions relating to exchange of goods & services and unilateral transfers. It includes record of:

(a) Export & import of goods/Merchandise (visible items): It includes export & import of visible items like wheat, rice, machinery etc. Movement of goods between countries is known as visible trade because the movement is open and can be verified by custom officials. Exports are recorded as credits and imports are recorded as debits. The net balance of visible trade, i.e. export minus import of goods is called balance of visible trade. If exports are more than imports then there is trade surplus and if imports are more than exports then there is trade deficit.

(b) Export & import of services (invisible items): Under this head, following types of services are included:
(I) Shipping, Insurance, Banking, Tourism & other miscellaneous services: Services include shipping, tourism, insurance & other miscellaneous services like management fees, subscription to journals, telephone services etc. Payments are either received or made for the use of these services. When services are rendered to non-residents these are recorded on the credit side as they result in the inflow of foreign exchange. When these are rendered to the residents by the non-residents these are recorded on debit side as they result in outflow of foreign exchange.
(ii) Investment income: When foreign companies make investment in India’s industry and trade, the profit made by them in India have to be paid to their shareholders in the form of dividend. Similarly, interest has to be paid to foreign credits for money borrowed in the past. Thus dividend and interest payments result in outflow of foreign exchange. In the same way, India may receive dividend & interest payments which result in inflow of foreign exchange.
(iii) Unilateral transfers: These are unrequited transfers or unilateral transfers between residents & nonresidents. These can be private which include gifts, donations etc. or official which include donations, grants in cash by foreign governments, contribution from UN, WHO etc. The net balance of invisible trade, i.e. export & import of services is termed as balance of invisible trade.

Balance of current account: It is equal to the difference between the sum of credits and the sum of debits on current account. It can be negative or positive. The sum of Net visible and Net invisible gives current account balance which can show surplus or deficit. The current account balance is transferred to capital account.

Question 2. What are official reserve transactions? Explain their importance in the balance of payments.

Ans. The transactions carried by monetary authority of a country, which cause changes in official reserves, are termed as official reserve transactions. These transactions are carried through purchase or sale of currency in the exchange market for foreign currencies or other assets. The reserves are drawn by selling foreign currencies in exchange market during deficits and foreign currencies are purchased during surplus. When the official reserves increases or decreases, it is called overall balance of payments surplus or deficit respectively.

Importance of official reserve transactions in balance of payments:
1. Purchase of a country’s own currency is a credit item in the balance of payments; whereas, sale of the currency is a debit item.
2. It helps to adjust the deficit and surplus in balance of payments.

Question 3. Distinguish between the nominal exchange rate and the real exchange rate. If you were to decide whether to buy domestic goods or foreign goods, which rate would be more relevant? Explain.

Ans. Nominal Exchange Rate: A nominal value is an economic value expressed in monetary terms (that is, in units of a currency). It is not influenced by the change of price or value of the goods and services that currencies can buy. Therefore, changes in the nominal value of currency over time can happen because of a change in the value of the currency or because of the associated prices of the goods and services that the currency is used to buy. When you go online to find the current exchange rate of a currency, it is generally expressed in nominal terms. The nominal rate is set on the open market and is based on how much of one currency another currency can buy.

Real Exchange Rate: The real exchange rate is the purchasing power of a currency relative to another at current exchange rates and prices. It is the ratio of the number of units of a given country’s currency necessary to buy a market basket of goods in the other country, after acquiring the other country’s currency in the foreign exchange market, to the number of units of the given country’s currency that would be necessary to buy that market basket directly in the given country. The real exchange rate is the nominal rate adjusted for differences in price levels.

A measure of the differences in price levels is Purchasing Power Parity (PPP) . The concept of purchasing power parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be on par with the purchasing power of the two countries’ currencies. Using the PPP rate for hypothetical currency conversions, a given amount of one currency has the same purchasing power whether used directly to purchase a market basket of goods or used to convert at the PPP rate to the other currency and then purchase the market basket using that currency. If I were to decide whether to buy domestic goods or foreign goods, Real Exchange rate would be more relevant.

Question 4. Suppose it takes 1.25 yen to buy a rupee, and the price level in Japan is 3 and the price level in India is 1.2. Calculate the real exchange rate between India and Japan (the price of Japanese goods in terms of Indian goods).
(Hint: First find out the nominal exchange rate as a price of yen in rupees).

Ans. Nominal Exchange Rate of Yen in Rupees= 1/1.25 = 4/5 = 0.80
Real Exchange Rate = Nominal Exchange Rate × Japan Price Level/Indian Price Level
0.80 × 3/1.2 = 2
The price of Japanese goods in terms of Indian goods is
2:1.

Question 5. Explain the automatic mechanism by which BOP equilibrium was achieved under the gold standard.

Ans. According to gold standard system, gold was taken as the common unit of parity between currencies of different countries in circulation. Each country was to define value of its currency in terms of gold. Accordingly, value of one currency in terms of the other currency was fixed considering gold value of each currency. This system was also known as Mint par value of exchange or Mint parity. It was prevalent in most countries prior to 1920s.

For example: if €1 = 5 gm of gold and $1 = 2 gm of gold, then exchange rate will be €1 = $2.5.Under the gold standard system, gold was taken as a common unit for measuring other country’s currency. Thus, the value of a currency was defined in terms of gold. The exchange rate in an open market was determined by its worth in terms of gold. It was fixed in lower limits and upper limits, under which it was allowed to fluctuate. So, the exchange rate became stable under gold standard. All the countries maintained stock of gold to exchange currency.

Question 6. How is the exchange rate determined under a flexible exchange rate regime?

Ans. Equilibrium exchange rate occurs where supply of and demand for exchange is equal to each other. It is the flexible rate of exchange. The adjoining figure illustrates determination of equilibrium exchange rate.

Equilibrium is determined at the point ‘E’ where both demand curve & supply curve intersect each other. DD is the demand curve & SS is the supply curve. The demand curve is downward sloping which shows inverse relation between price & quantity demanded of foreign exchange.
Supply curve is upward sloping which shows direct relationship between the rate and demand of foreign exchange.
Equilibrium exchange rate is OR and equilibrium quantity is OQ.

Change in exchange rate:

Suppose there is an increase in India’s demand for US dollars, supply remaining the same then it will cause the demand curve DD shift to D’D’. The resulting intersection will be at a higher exchange rate i.e. exchange rate will rise from OR to OR1. It shows depreciation of Indian Currency because more rupees are required to buy 1 US$. Thus, depreciation of currency means a fall in the price of home currency.

Similarly, if there is an increase in supply of US dollars will cause supply curve SS shift to S’S’ and as a result exchange rate will fall from OR to OR2. It indicates appreciation of Indian Currency. Thus, appreciation means a rise in price of home currency.

Question 7. Differentiate between devaluation and depreciation.

Ans. In both the value of currency falls but in the former it falls due to government action and in the latter it falls due to market forces of demand and supply.
• Devaluation: Devaluation refers to reduction in the value of domestic currency by the government.
• Currency depreciation: It refers to decrease in the value of domestic currency in terms of foreign currency. It makes the domestic currency less valuable and more of it is required to buy foreign currency. It happens when demand of a currency increases without any change in supply. For example: if demand for US dollars increases, supply remaining the same,the exchange rate will raise. It implies appreciation of US dollars or depreciation of Indian Rupees.

Implication of depreciation and devaluation is same:

Its implication is that with the same amount of dollars, more goods can be purchased from India.This means Indian goods become cheaper for America. This may result in increase of exports from India to rest of the world and decrease in imports from rest of the world to India. It will also increase other ways of inflow of foreign exchange and reduce other ways of outflow of foreign exchange. Therefore, BOP deficit gets corrected.

Question 8. Would the central bank need to intervene in a managed floating system? Explain why?

Ans. Managed Floating Rate System refers to a system in which foreign exchange rate is determined by market forces and central bank is a key participant to stabilize the currency in case of extreme depreciation or appreciation.It is also known as ‘dirty floating’. In this system, central bank intervenes to restrict fluctuations in the exchange rate within certain limits. The aim is to keep exchange rate close to desired target values. Had there been no intervention from government, we would have called it floating system i.e. a system in which exchange rate floats as per market forces but we are naming it managed floating because the float in exchange rate is being managed by central bank intervention.

Question 9. Are the concepts of demand for domestic goods and domestic demand for goods the same

Ans.No, the concept of demand for domestic goods and domestic demand for goods is not same. Demand for domestic goods is the sum total of demand for the goods of a country produced within its domestic territory + export demand from rest of the world.Domestic demand for goods refers to total demand for goods and services by the residents of a country. It is equal to total of demand for the goods of a country produced within its domestic territory – import demand to rest of the world.

Question 10. What is the marginal propensity to import when M = 60 + 0.06Y ? What is the relationship between the marginal propensity to import and the aggregate demand function?
Note: Deleted from the syllabus.

Question 11. Why is the open economy autonomous expenditure multiplier smaller than the closed economy one
Note: Deleted from the syllabus.

Question 12. Calculate the open economy autonomous expenditure multiplier smaller than the closed economy one?
Note: Deleted from the syllabus.

Question 13. Suppose C = 40+0.8Y D, t = 50, I = 60, G = 40, X = 90, M = 50 + 0.05Y (a) Find equilibrium income. (b) Find the net export balance when the government purchases increase from 40 and 50?
Note: Deleted from the syllabus.

Question 14. In the above example, if exports change to X = 100, find the change in equilibrium income and the net export balance.
Note: Deleted from the syllabus.

Question 15. Explain why G – T = (Sup-I) – (X-M).
Note: Deleted from the syllabus.

Question 16. 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?

Ans. Trade balance of country A will get adverse because its imports will increase and its exports will decrease. On the other hand, Trade balance of country B will get favourable because its imports will decrease and its exports will increase.

Question 17. Should a current account deficit be a cause for alarm? Explain.

Ans. Current account deficit is the excess of total imports of goods, services and transfers over total exports of goods, services and transfers. This situation makes a country debtor to the rest of the world. But, this cannot be always treated as a cause for alarm because countries might be running in deficits (current account) to increase productivity and exports in future. Also, more investment will help in building capital stock, which in future will lead to rise in output.

Question 18. Suppose C =100 + 0.75Y D, I = 500, G = 750, taxes are 20 per cent of income X = 150, M = 100 + 0.2Y. Calculate equilibrium income, the budget deficit or surplus and the trade deficit or surplus.
Note: Deleted from the syllabus.

Question 19. Discuss some of the exchange rate arrangements that countries have entered into to bring about stability in their external accounts.

Ans.To combine the two extreme positions, `fixed’ and ‘flexible’, the following exchange rate arrangements are used by governments to bring stability in external accounts

1. Wider Bands
A system that allows adjustment in fixed exchange rate is referred to as wider bands. It permits only 10% variation between the currencies of any two countries. For example, a country can improve its balance of payments (BP) deficit by depreciating it’s currency, which leads to increase in demand for domestic goods due to increase in purchasing power of other currencies. This further leads to the increase in exports, hence improving the BOP

2. Crawling Peg
Crawling peg system allows continuous and regular adjustments in the exchange rate. Only 1% of variation is allowed at a time.

3. Managed floating
Managed floating is a scheme under which government can intervene to vary the exchange rate when the situation demands so. There is no specific limit of variation as in crawling peg and wider bands.

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