Balance of Payments and Forex 4 Marks Important Questions

Balance of Payments and Forex Important Questions

1. Difference between autonomous and accommodating items.


Autonomous itemsBasisAccommodating items
Autonomous items refer to those international economic transactions, which take place due to some economic motive such as profit maximization.MeaningAccommodating items refers to the compensating capital transactions that are undertaken to cover deficit or surplus in autonomous transactions i.e., such transactions are determined by the net consequences of autonomous transactions. 
Autonomous transactions are independent of the state of the BoP account.Effect on BoP AccountAccommodating transactions are dependent on BoP status as they are undertaken by the central bank of a nation to maintain balance in the BoP account.
Autonomous transactions take place on both current and capital accounts.OccurrenceAccommodating transactions take place only on capital accounts.
These items are also known as ‘above the line items’.Alternate namesThese items are also known as ‘below the line items’.

2. Difference between devaluation and depreciation.


Devaluation refers to a reduction in the price of domestic currency in terms of all foreign currencies under a fixed exchange rate regimeMeaningDepreciation refers to a fall in the market price of domestic currency in terms of a foreign currency under a flexible exchange rate.
It takes place due to Government.OccurrenceIt takes place due to market forces of demand and supply.
It takes place under a fixed exchange rate systemExchange Rate SystemIt takes place under a flexible rate system.

3. Differentiate between fixed exchange rate and flexible exchange rate?


Fixed Exchange RateBasisFlexible Exchange Rate
It is officially fixed in terms of gold or any other currency by the government.Determination of Exchange RateIt is determined by forces of demand and supply of foreign exchange.
It ensures stability in the international money market/ exchange market. Day-to-day fluctuations are avoided and only a small variation is possible.StabilityIt causes instability in the international money market.
It implies low risk and low uncertainty of future payments. It encourages international trade.International TradeIt implies high risk due to fluctuations in the exchange rate which lowers international trade.
The government is required to keep a large stock of foreign exchange reserves to maintain the fixed rate of exchange at a particular level.Foreign Exchange ReservesThere is no need to create foreign exchange reserves as the rate of exchange is determined by market forces.
Fixed Exchange Rate leads to(i) Devaluation when there is a decrease in the value of the domestic currency by the government. (ii) Revaluation, when there is an increase in the value of the domestic currency by the government.An Increase or Decrease in the Value of Domestic Currency.Flexible Exchange Rate leads to(i) Depreciation i.e., a decrease in the value of the domestic currency in terms of foreign currency by market forces of demand and supply. (ii) Appreciation i.e., increase in value of the domestic currency in terms of foreign currency by market forces of demand and supply.

4. Distinguish between the balance of trade and the balance of payment.


Balance of trade (BoT)BasisBalance of Payment (BoP)
Those transactions arise out of the exports and imports of goods. It does not consider the exchange of services rendered such as shipping, Insurance, banking, etc.MeaningThe balance of payments of a country is a systematic record of all economic transactions between the residents of a country and the rest of the world, in a given period.
It is a narrow concept as it is a component of the balance of payments.ConceptIt is a wider concept.
It includes only visible items.Nature of itemsIt includes both visible and invisible items.
It is a partial record. Hence, it is not a true indicator of economic relations with other countries.Nature of recordIt is the complete record of economic transactions with the rest of the world. Hence, it provides a true picture of the economy to the rest of the world.
The deficit in BoT(Unfavorable BoT) can be met out with a favorable BoP.SettlementThe deficit in BoP (Unfavorable BoP) cannot be met by favorable BoT.

5. Write down the merits and demerits of the fixed exchange rate system.

Ans. Merits

(i) Market Stability: The stability of the market is key merit of a fixed exchange rate. It promotes investment across nations.

(ii) Stable Macroeconomic Policies: Given the fixed exchange rate, the central bank can frame its monetary policy and the government can frame its fiscal policy, independent of the external shocks relating to fluctuations in the exchange rate.

(iii) Devaluation- A Key Tool to expand Foreign Market for the Domestic Producers: Fixed exchange rate system allows devaluation of the currency. It is a planned fall in the value of the domestic currency. It helps expand the foreign market for domestic producers.


(i) Reserves of Forex: To maintain the rate of exchange at the desired level, the government needs to keep a large stock of foreign exchange. This is the principal demerit of the fixed exchange rate system.

(ii) Inefficient Allocation of Resources: The exchange rate fixed by the government often deviates from the equilibrium exchange rate (in a free market economy). To that extent, the allocation of resources may not be efficient.

(iii) Small Sze of Forex Market: When the rate of exchange is fixed, foreign exchange does not emerge as a trading commodity. Accordingly, the size of the forex market remains small. This acts as a hurdle to global economic growth.

6. Write down the merits and demerits of the flexible exchange rate system.

Ans. Merits

(i) Large Reserves of Forex not required: Flexible system of exchange rate does not require large reserves of foreign exchange with the government. Market forces of supply and demand automatically drive the rate of exchange to the point of equilibrium.

(ii) Efficient Allocation of Resources: Efficient allocation of resources is achieved, as the system is ruled by the free play of the market forces.

(iii) Large Size of the Forex Market: Since foreign exchange itself becomes a trading commodity, the size of the forex market tends to be large. This induces economic growth across all parts of the world.

(iv) International Mobility of Liquidity: Since large reserves of forex are not required, a flexible exchange rate tends to promote international mobility of liquidity. This is good for the less developed countries (like India), where foreign investment is a significant determinant of GDP growth.


(i) Marginalisation of Weak Currencies: Flexible exchange rate system leads to the marginalization of weak currencies in the international money market. Weak currencies (of small economies) often suffer huge depreciation from strong currencies (of big economies). Accordingly, gains in international trade accrue more to the large economies than the small economies.

(ii) Uncertainty of the Market: There is a high degree of uncertainty in the market. Owing to the frequently changing rate of exchange, it becomes difficult to formulate a stable monetary policy in the domestic economy.

(iii) External Shocks: Flexible exchange rate system exposes the domestic economy to external shocks. Example: As and when the US dollar appreciates (about the Indian rupee), the burden of import payments tends to rise, even when the international price of the goods is constant. Because payments are to be made I n terms of dollars, ann d (after a rise in the n exchange rate) a larger amount of the Indian currency is needed to pay the same amount of dollars.

7. What is the nominal exchange rate (NER)?

Ans. The nominal exchange rate is the rate at which currency can be exchanged. If the nominal exchange rate between the dollar and the Indian rupee is 78, then one dollar will purchase 78 INR. Exchange rates are always represented in terms of the amount of foreign currency that can be purchased for one unit of the domestic currency. Thus, we determine the nominal exchange rate by identifying the amount of foreign currency that can be purchased for one unit of the domestic currency. 

A decrease in this variable is termed nominal appreciation of the currency. (Under the fixed exchange rate regime, a downward adjustment of the rate Eis termed revaluation.) An increase in this variable is termed the nominal depreciation of the currency. (Under the fixed exchange rate regime, an upward adjustment of the rate E is called devaluation.)

8. What is the real exchange rate (RER)?

Ans. The real exchange rate R is defined as the ratio of the price level abroad and the domestic price level, where the foreign price level is converted into domestic currency units via the current nominal exchange rate. It determines the actual purchasing power of that currency Formally, R=(NER.P*)/P, where the foreign price level is denoted as P* and the domestic price level as P. A decrease in R is termed appreciation of the real exchange rate, an increase is termed depreciation.

The real rate tells us how many times more or fewer goods and services can be purchased abroad (after conversion into a foreign currency) than in the domestic market for a given amount. In practice, changes in the real exchange rate rather than its absolute level are important. In contrast to the nominal exchange rate, the real exchange rate is always ”floating”, since even in the regime of a fixed nominal exchange rate E, the real exchange rate R can move via price-level changes.

9. What is the Nominal effective exchange rate (NEER)?

Ans. The concept is useful for an aggregative analysis. A nation has to deal with several countries, and hence several currencies.

(ii) For example, during a period Indian rupee may be losing value against The American dollar, but may be gaining value against Euro.

(iii) Therefore, we would be interested in knowing what is happening in the aggregate to our rupee i.e., it is gaining or losing.

(iv) For this purpose, we prepare a basket of all the currencies which we are interested in, and find out the average of the changes in these currencies in a given period. This gives us the nominal effective exchange rate (NEER).

(v) So, finally NEER is the measure of the average relative strength of a given currency concerning other currencies without eliminating the effect of price change.

10. What is the Real Effective exchange rate (REER)?

Ans. The real effective exchange rate (REER) compares a nation’s currency value against the weighted average of the currencies of its major trading partners.

  1. It is an indicator of the international competitiveness of a nation in comparison with its trade partners.
  2. The formula is weighted to take into account the relative importance of each trading partner to the home country.
  3. An increasing REER indicates that a country is losing its competitive edge.
  4. A nation’s nominal effective exchange rate (NEER), adjusted for inflation in the home country, equals its real effective exchange rate (REER).

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