Macro

Balance of Payments

Easy

Comprehension:

THE FOREIGN EXCHANGE MARKET

The market in which national currencies are traded with one another is known as the foreign exchange market. The major participants in the foreign exchange market are commercial banks, foreign exchange brokers and other authorized dealers and monetary authorities. It is important to note that although participants themselves may have their own trading centers, the market itself is world-wide. There is close and continuous contact between the trading centers and the participants deal in more than one market.

Foreign currency flows into the home country for the following reasons: exports by a country lead to the purchase of its domestic goods and services by foreigners; foreigners send gifts or make transfers; and, the assets of a home country are bought by foreigners. A rise in the price of foreign exchange will reduce foreigners’ costs while purchasing products from India and other things will remain constant. This increases India’s exports and hence the supply of foreign exchange may increase.

Different countries have different methods of determining their currency’s exchange rate. It can be determined through Flexible Exchange Rate, Fixed Exchange Rate or Managed Floating Exchange Rate. Floating exchange rate is determined by the market forces of demand and supply. Where fixed exchange rate is determined by the government at a particular level. In floating exchange rate increasing value of currency is known as appreciation and a decreasing value is known as devaluation where in fix exchange rate decreased value is known as devaluation. Managed floating exchange rate is combination of flexible and fixed exchange rate where at certain movement central intervene through market operation to manage currency exchange rate.

When income increases and due to increase in income the demand for foreign goods increases then in this scenario what impact does economy face on foreign exchange rate ?

Appreciation of domestic currency.

Devaluation of domestic currency.

No change in domestic currency rate.

Depreciation of domestic currency.

✅ Correct Option: 4

Option 1 -> When domestic currency appreciates, it becomes stronger, but increased import demand weakens it, not strengthens it.

Option 2 -> Devaluation is a deliberate government policy action in fixed exchange rate systems, not a market-driven outcome.

Option 3 -> Increased demand for imports affects foreign exchange markets, so currency rates must change.

Option 4 -> When demand for foreign goods rises, citizens need more foreign currency to pay for imports, increasing supply of domestic currency in forex market.

Hence, Option 4: Depreciation of domestic currency -> When income increases and people buy more foreign goods (imports), they need to exchange domestic currency for foreign currency. This increases the supply of domestic currency and demand for foreign currency in the foreign exchange market. As per demand-supply dynamics, increased supply of domestic currency leads to a fall in its value, causing depreciation. Depreciation is a market-driven decline in currency value under floating exchange rate systems, which is exactly what happens when import demand rises. -> correct

Question 46

An increase in exchange rate implies that the price of foreign currency in terms of domestic currency has increased; this is called ........

Question 47

When the central bank intervenes to control the exchange rate through sell/purchase of foreign currencies, this process is called______

Question 48

In an economy, to control a high balance of payment problem if government decided to reduce its currency value against globally accepted foreign currency, this process this known as:

Question 50

The place where currencies are traded is known as .........

When income increases and due to increase in income the demand for foreign goods increases then in this scenario what impact does economy face on foreign exchange rate ?

Solution

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