Foreign Exchange Rate and Balance of Payments Class 12 Economics Notes and Questions

Please refer to Economics Foreign Exchange Rate and Balance of Payments Class 12 Economics Notes and important questions below. The Class 12 Economics Chapter wise notes have been prepared based on the latest syllabus issued for the current academic year by CBSE. Students should revise these notes and go through important Class 12 Economics examination questions given below to obtain better marks in exams

Foreign Exchange Rate and Balance of Payments Class 12 Economics Notes and Questions

The below Class 12 Foreign Exchange Rate and Balance of Payments notes have been designed by expert Economics teachers. These will help you a lot to understand all important topics given in your NCERT Class 12 Economics textbook.

Balance of Payment

Question. What is balance of payment account?
Ans. It is a systematical record of all economic transactions carried out by the normal residents of a country with ROW during a financial year. In other words, it is the summary of all the international transactions of a nation in a year. It is based on double entry system of accounting principle where all the inflows of foreign exchange are recorded at credit side and all the outflows of foreign exchange are recorded at debit side.

Question. What are the components of BOP A/c?
Ans. 1. Exports and imports of goods: It records all the transactions of inflow and outflow of foreign exchange as a result of exports and imports of visible items i.e. goods like machines, clothing, crude oil, etc.
2. Import and export of services: It records all the transactions of inflow and outflow of foreign exchange as a result of exports and imports of invisibles i.e. services like shipping, banking, tourism, etc.
3. Unilateral receipts and payment: It refer to all those unilateral transactions don’t create any claim of repayment against any receipts. It includes gifts, donations, remittances, etc. received from abroad or paid to abroad.
4. Capital receipts and payments: It includes all the transactions of inflow and outflow of foreign exchange resulting from change in assets and liabilities of the normal residents of a country. Eg., Borrowing and lending from abroad, sale and purchase of assets with the foreigners.

Question. Distinguish between Balance of Trade(BOT) and BOP.
Ans. Balance of trade: It is the difference between exports and imports of goods of a nation during a year.
Balance of payment: It is a systematical record of all the international transactions of a nation during a year.
BOP is a wider concept than BOT. Their difference is given as below.

Question. Distinguish between current account and capital account of BOP.
Ans. BOP A/c is divided into 2 parts.
1. Current account: It refers to that part of BOP A/c which records all those transactions of inflow and outflow of foreign exchange caused by exports and imports of goods and services and unilateral transactions.
Thus, balance of current account is obtained by the sum of BOT, balance of service and balance of unilateral transfer.
2. Capital account: It refers to that part of BOP A/c which record all those transactions of inflow and outflow of foreign exchange resulting from change in assets and liabilities of normal residents of a country or its government.
It includes borrowings or lending to abroad, investment from and to abroad and change in foreign exchange reserve.

Question. Explain the components of capital A/c of BOP.
Ans. 1. Borrowings from and to abroad: It includes borrowings from abroad or lending to abroad by private and government sector. Receipts of loan from abroad and repayment of loan by foreigners are recorded on credit side. But, lending to abroad and repayment of loan to foreigners are recorded on debit side.
2. Investment from and to abroad: There are two types of investment: –
a. Direct investment- In this investment, purchaser acquire direct control over the assets.
Eg., Purchase of office in abroad.
b. Portfolio investment- In this investment, purchaser gets the ownership but does not get direct control over the assets.
Eg., Purchase of equity share of a foreign company.
All the transactions of investment from abroad which cause inflows foreign exchange are recorded on credit side but transactions of investment to abroad which cause outflows of foreign exchange are recorded on debit side.
3. Change in foreign exchange reserve: Central bank may also use stock of foreign exchange reserve to finance BOP A/c. Any withdrawal from foreign exchange reserve will be recorded on credit side of BOP A/c and any deposits into foreign exchange reserve will be recorded on debit side of BOP A/c.

Question. What are accommodating and autonomous items of BOP.
Ans. Autonomous items of BOP- It refers to those international economic transactions which take place in BOP due to some economic motives like profit maximisation.
So, these transactions are independent of the state of country’s BOP. They are called ‘items above the line’.
Thus, surplus or deficit in BOP is caused by autonomous transactions. If sum of autonomous receipts is more than sum of autonomous payments in BOP, it is called surplus in BOP. If sum of autonomous receipts are less than sum of autonomous payment, it is called deficit in BOP.
Accommodating items refers to those international transactions which take place due to other transactions in BOP. In other words, accommodating transactions take place to correct disequilibrium (surplus or deficit) in BOP. Eg., Government financing.
So, accommodating transactions are determined by the consequence of autonomous transactions of BOP. They are also called ‘items below the line’

Question. What are the causes for disequilibrium in BOP?
Ans. Disequilibrium (surplus or deficit) in BOP is caused by following reasons: –
1. Economic factors:
a. Development activities- Developing countries like India has to import machinery, technology, etc. on large scale. So, their payment to abroad cause deficit in BOP.
b. Inflation- If there is rapid increase domestic price level, then foreign product became relatively cheaper, it will increase imports and decrease exports which results deficit in BOP.
c. Cyclic fluctuation- If there is boom phase in a country and domestic producer are not able to meet domestic demand. So, it will increase imports which will increase deficit in BOP.
2. Political factors- Disequilibrium in BOP is also affected by political factors. Political instability and disturbance in an economy discourage inflow of capital and encourage outflow of capital. So, it also causes deficit in BOP.
3. Social factors: Surplus or deficit in BOP is also caused by change in social factors like taste, fashion, etc.

Foreign Exchange

Question. What is foreign exchange, foreign exchange rate and foreign exchange market?
Ans. 1. Foreign exchange: All currencies in the world other than domestic currency is called foreign exchange.
2. Foreign exchange rate: It is the rate at which currency of one nation is exchanged by the currency of another nation. Thus, it is the price of one currency in terms of currency of another nation.
3. Foreign exchange market: It is the market where currency of various nations are converted, traded and exchanged.

Question. What is fixed exchange rate and floating/flexible exchange rate?
Ans. Fixed exchange rate: It is the rate of foreign exchange which is officially fixed by government or monitory authority or and not by market forces of demand and supply. Only a small deviation in the fixed value is possible.
Foreign banks are always ready to buy or sell their currency at a fixed rate. This kind of exchange rate was used under gold standard system in which all the countries committed to convert their currencies in terms of gold.
Floating/ Flexible exchange rate system: It is the system of rate of foreign exchange in which foreign exchange rate is determined by market forces of demand and supply of foreign exchange. There is no official intervention by central bank rather, value of currency can adjust freely according to change in demand and supply of foreign exchange.

Question. What are the sources of demand for foreign exchange?
Ans. In an economy, foreign exchange is demanded by citizens of a country by the following ways: –
1. To purchase goods and services from abroad
2. To directly invest in real assets like land, building, office in abroad etc.
3. To purchase financial assets like shares, debentures, bonds etc. for speculation in foreign market.
4. To undertake any foreign tour.
5. To send gifts in abroad.

Question. What are the sources of supply of foreign exchange in a country?
Ans. In an economy, foreign exchange is supplied by foreigner by following sources:
1. When foreigner purchases goods and services from the market of domestic country.
2. When foreigner directly invest in real assets like land, building, etc. in the domestic country.
3. When foreigner purchases financial assets like shares, debentures, etc. for speculation in the market of domestic country.
4. When foreigner undertake any tour in domestic country.

Question. What is depreciation of currency? Explain its impact on imports and exports. How is it different from devaluation of currency?
Ans. Depreciation of currency refers to fall in the value of domestic currency in the terms of foreign currency. Eg., If price of $1 increases from ₹60 to ₹70 then, it is the depreciation of Indian currency because now more Indian currency is required to buy $1.

Impact of imports and exports: With depreciation of currency, domestic product becomes relatively cheaper for foreigners. So, it will increase exports of country whereas, foreign products become relatively costly for the people of domestic country. Thus, it will decrease imports.

Difference between depreciation and devaluation of currency
Depreciation of currency means fall in value of currency due to change in market forces of demand and supply of foreign exchange. So, it is done under flexible exchange rate system.
Devaluation of currency means fall in the value of currency in terms of foreign currency by the government. So, it is done under fixed exchange rate system.

Question. What is appreciation of currency? Explain its impact on imports and exports. How is it different from revaluation of currency?
Ans. Appreciation of currency refers to rise in the value of domestic currency in the terms of foreign currency. Eg., If price of $1 decreases from ₹70 to ₹60 then, it is the appreciation of Indian currency because now less Indian currency is required to buy $1.

Impact of imports and exports: With appreciation of currency, domestic product becomes relatively costlier for foreigners. So, it will decrease exports of country whereas, foreign products become relatively cheaper for the people of domestic country. Thus, it will increase imports.

Difference between appreciation and revaluation of currency
Appreciation of currency means rise in value of currency due to change in market forces of demand and supply of foreign exchange. So, it is done under flexible exchange rate system.
Revaluation of currency means rise in the value of currency in terms of foreign currency by the government. So, it is done under fixed exchange rate system.

Question. How is foreign exchange rate determined?
Ans. In the flexible exchange rate system, rate of foreign exchange is determined by market forces of demand and supply of foreign exchange.
Demand for foreign exchange is inversely related to foreign exchange rate. So, demand curve for foreign exchange is downward sloping from left to right.
Supply of foreign exchange is directly related to foreign exchange rate. So, supply curve for foreign exchange is upward sloping from left to right.
Equilibrium exchange rate is determined where demand for foreign exchange is equal to supply of foreign exchange.
At exchange rate R1, there is excess supply. So, there will be competition among the sellers, so exchange rate decreases.
At exchange rate R2, there is excess demand. So, there will be competition among the buyers, so exchange rate increases.
Thus, equilibrium exchange rate is R where demand and supply of foreign exchange is equal.

Question. Why does demand for foreign exchange increase when foreign exchange rate decrease?
Ans. When foreign exchange rate decreases, demand for foreign exchange will increase due to following reasons: –
1. When foreign exchange rate decreases, foreign products become relatively cheaper for the people of domestic nation. So, it increases the demand of foreign goods and services which further increases demand for foreign exchange.
2. As foreign exchange rate decreases, foreign tour become comparatively cheaper, so it promotes foreign tourism and thereby increases the demand for foreign exchange.
3. With decrease in foreign exchange rate, investment in abroad for speculation become more profitable which also increase the demand for foreign exchange.

Question. Why does supply of foreign exchange increases when foreign exchange rate increases?
Ans. When foreign exchange rate increases, supply for foreign currency will increase due to following reasons: –
1. As rate of foreign exchange rate increases, domestic product become relatively cheaper for foreigners. So, it increases exports of country and supply of foreign exchange will increase.
2. When foreign exchange rate increases, domestic tour become cheaper for foreigners. So, it encourages domestic tourism and thereby increase the supply of foreign exchange.
3. With increase in rate of foreign exchange, investment in domestic country by foreigners in speculative activities become more profitable which also increase the supply of foreign exchange.

Question. What is managed floating exchange rate system?
Ans. It refers to that system of foreign exchange in which foreign exchange rate is determined by market forces of demand and supply of foreign exchange, but central bank is a key participant to stabilize the value of currency in case of extreme appreciation or depreciation of currency.