Question

Read the passage given below and answer the questions that follow.

A change in the rupee-dollar exchange rate represents a change in the external value of the rupee. The value of the rupee, in terms of the dollar, has been falling continuously over a period of time. Since the rupee-dollar exchange rate is determined by the demand for and supply of dollars, it is possible that the value of the rupee will slide further if appropriate measures are not taken. The Reserve Bank of India, in charge of both the internal and external value of the rupee, has repeatedly emphasised maintaining stability in the foreign exchange market.

1. What kind of exchange rate system is being referred to in the passage?
2. The value of the rupee, in terms of the dollar, has been falling continuously over a period of time.” Give the economic term for this phenomenon.  
3. How would this phenomenon affect balance of payments? 
4. Explain the role of the Reserve Bank of India as custodian of foreign exchange. 
5. Suggest any two measures to correct adverse balance payments.

Answer 1

1. The passage refers to the flexible exchange rate.
2. The economic word for this process is depreciation.
3. This phenomenon affects the Balance of Payments (BOP) situation.
   1. Due to the depreciation of the domestic currency, the same unit of foreign currency is available in exchange for domestic currency.
   2. This makes imports expensive and exports cheaper. Hence, Imports will fall and exports will rise. This will also attract the FDI of a domestic country. Hence, there will be a surplus in the BOP of that country.
4. Custodian of foreign exchange:
   1. The Central Bank holds foreign exchange reserves such as US dollars and British pounds. The Central Bank's right contributes to maintaining exchange rate stability and overcoming balance of payment difficulties. All foreign currency received must be deposited at the Central Bank for this reason.
5. Adverse Balance of Payments(BOP) means a deficit in the Balance of Payment(BOP) account.

Two measures to control adverse Balance of payment are:

1. 1. Import Restrictions: Import restrictions might include quotas or prohibitions on non-essential commodities. One consequence of this strategy is that it may prevent access to vital foreign items and disrupt the supply of raw materials for certain sectors.
   2. Currency Depreciation: Currency depreciation occurs when the value of a currency falls relative to other currencies. This has a favourable impact on increasing exports while discouraging imports. Exchange depreciation increases a country's exports by making the domestic market more affordable for international businesses.