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Class 12 - Economics
Foreign Exchange Rates Test - 01

1. If at a given point of time, the exchange value of dollar changes from 1 = ₹60to 1 = ₹ 65, we cannot say precisely that
a) all of these
b) the rupee has devalued
c) the rupee has appreciated
d) the rupee has depreciated
2. The demand curve for foreign exchange is
a) Downward sloping
b) Upward sloping
c) Horizontal
d) Vertical
3. Point out merit of flexible exchange rate.
a) None of these
b) Frees the govt from holding any foreign exchange reserves
c) Frees the private sector from holding any foreign exchange reserves
d) Frees the individual from holding any foreign exchange reserves
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4. Foreign exchange reserves increase if:
a) Govt. increases taxes
b) Govt. increases taxes and Exports increase imports remain the same
c) Imports increase exports remain the same
d) Exports increase imports remain the same
5. Match the following:
(a) Currency devaluation (i) decrease the value of domestic currency in terms of foreign currency

(b) Currency revaluation (ii) reduction in the value of domestic currency by the govt.

(c) Currency appreciation (iii) increase in the value of domestic currency by the govt.

(d) Currency depreciation (iv) increase the value of domestic currency in terms of foreign currency
6. Distinguish between devaluation and depreciation of a currency.
7. State two sources of demand for foreign exchange.
8. What happens to equilibrium exchange rate when supply for foreign exchange increases, demand remaining the same?
9. Would the central bank need to intervene in a managed floating system? Explain why?
10. What is ‘appreciation’ of domestic currency? What is its likely effects on export and how?
11. When the price of a foreign currency falls, the supply of that foreign currency also falls. Explain why?
12. Mention any four sources of demand of foreign currency.
13. What is Foreign Exchange Market? State its functions.
14. i. Define Trade Surplus and Trade Deficit.
ii. Discuss briefly the concept of managed floating system of foreign exchange rate determination.
15. How is exchange rate determined in the foreign exchange market? Explain.

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Class 12 - Economics
Foreign Exchange Rates Test - 01

Solution

1. (c) the rupee has appreciated

2. (a) Downward sloping
Explanation: At lower exchange rate more foreign currency is demanded and at higher exchange rate less foreign
currency is demanded.
3. (b) Frees the govt from holding any foreign exchange reserves
Explanation: The system of flexible exchange rates eliminates the need for official foreign exchange reserves, if the
individual governments do not employ stabilization funds to influence the rate. Thus, the problem of international
liquidity is automatically solved. In fact, the present shortage of international liquidity is due to pegging the exchange
rates and the intervention of the IMF authorities to prevent fluctuations in the rates beyond a narrow limit.
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4. (d) Exports increase imports remain the same
5. (a) - (ii), (b) - (iii), (c) - (iv), (d) - (i)
6. Both devaluation and depreciation mean fall in the external purchasing power of a currency but devaluation is issued
under fixed exchange rate system while depreciation is used under floating exchange rate system.
7. i. Repayment of international loans - International loans are raised in terms of foreign currency. so, foreign currency is
needed to repay these loans.
ii. Investment in rest of the world or foreign investment - We need currency of the country in which investment is to be
made. For eg. US dollars will be demanded for investment in USA.
8. Fall in exchange rate
9. The managed floating system is a combination of two systems − fixed and floating exchange rate systems. It calls for the
government or central bank to intervene when the need for the same is needed. The government or the central bank helps
in moderating the exchange rate movements by purchasing and selling the foreign currency. Thus, to avoid dirty floating,
the government exercises its power to intervene, whenever the need arises. sometime it is also called managed floating
system and this process is going on by the official reserve transaction process that is done by the rbi.
10. Currency appreciation refers to the increase in the value of domestic currency in terms of foreign currency. It makes the
foreign goods cheaper in domestic country as more of such goods can now be purchased with the same amount of
domestic currency. So it leads to an increase in imports. For example, a change from US 1 dollar = 45 to US 1 dollar =
40 represents that the Indian Rupees is appreciating.
11. The supply of foreign currency is directly proportional to the price of foreign exchange. There is a positive relationship
between supply and foreign exchange. When the price of a foreign currency falls, domestic goods become relatively
costlier. It induces the foreign countries to reduce their imports from the domestic country, i.e. it leads to cheaper imports
and costlier as there is an appreciation of domestic currency. The exporters are discouraged due to costlier exports For
example if the price of 1 US dollar falls from Rs. 45 to Rs. 40, then exports to the USA will decrease as Indian goods
will become relatively costlier. This results in lesser inflow or supply of foreign currency in the economy. As a result,

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the supply of foreign exchange decreases from OQ2 to OQ1.

12. (i) Imports (ii) Tourism (iii) Repayment of International loans (iv) Speculations
13. Foreign exchange market is that market that handles supply and demand (and therefore trade) of the currencies of
different countries and thus by handling demand and supply of currencies, it decides the exchange rate of one country in
terms of another. Briefly, the foreign exchange market refers to the market for National currencies of different countries
in the world.
The main functions are:
i. The foreign exchange market facilitates the conversion of one currency to another & thus facilitates the transfer
of purchasing power. This is called the Transfer function.
ii. Foreign exchange market facilities credit for international trade. This is called the Credit function of the market.
iii. Foreign exchange market facilities protection against risks of foreign exchange. This is called the Hedging function
of the market.
14. i. If a country exports a greater value than it imports, it has a trade surplus or positive trade balance, and conversely,
if a country imports a greater value than it exports, it has a trade deficit or negative trade balance.
ii. Managed floating exchange rate system is the amalgamation of the flexible exchange rate system and the fixed
exchange rate system. Under this system, central banks intervene to buy and sell foreign currencies in an attempt to
moderate exchange rate movements. This system is also called ‘dirty floating’.
15. Flexible exchange rate is determined by the interaction of the forces of demand and supply. The equilibrium exchange
rate is determined at a level where demand for foreign exchange is equal to the supply of foreign exchange. This will be
clear from Fig. (A)

As seen in the diagram, demand and supply of foreign exchange are measured on the X-axis whereas rate of foreign
exchange on the Y-axis. DD is the down ward sloping demand curve of foreign exchange and SS is the upward sloping
supply curve of foreign exchange. Both the curves intersect each other at point ‘E’ The equilibrium exchange rate is
determined at OR and equilibrium quantity is determined at OQ. Any exchange Rate (other than OR) is not the
Equilibrium Exchange Rate.
i. If the exchange rate is more than equilibrium rate. If the exchange rate rises to OR then demand for foreign
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exchange will fall toOQ and supply will rise to OQ . It will be a situation of excess supply. As a result, exchange
2 1

rate will fall till it again reaches the equilibrium level of OR.
ii. If the exchange rate is less than equilibrium rate. If exchange rate falls to OR , then demand will rise to OQ and
1 1

supply will fall to OQ . It will be a case of excess demand. It will push up the exchange rate till it reaches OR.
2

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