Q. 1. If PPP holds and if a basket of goods is priced at $ 100 in the US costs in £ 80 UK, what will be the exchange rate between and $?
Ans. Purchasing power parity means when exchange rate is determined by the relative purchasing power of the currency. According to PPP, the pound-dollar exchange rate will be equal to
£ 80 = $ 100 therefore
£1 = $1.25/ (100/80)
Q. 2. Suppose if UK prices rise by 10% while the US prices rise by 5% what will be new exchange rate?
Ans. If UK prices rise by 10% while the US prices rise by 5% basket of goods will be newly priced at $105 (100 + 5% of 100) in the US costs in 88 (80+ 10% 0f 80) UK. Therefore, new exchange rate will be
£ 88 = $ 105 therefore
£1 = $1.19/ (105/88)
Q. 3. Following a BOP crisis in 1991, the Indian government devalued rupee by over 30%. Explain why?
Ans. An action by the central bank to reduce the value of domestic currency vis-à-vis foreign currencies is called devaluation of a currency. When there is BOP crisis, it means there is BOP deficit. Under a fixed or pegged exchange rate regime, BOP deficit is adjusted against the available foreign exchange reserves. But if there is disequilibrium for a long time consistently, then there will be shortage in foreign exchange reserves and it will not be possible to correct BOP disequilibrium by selling available reserves. In such a severe crisis, as India faced in 1991, when our exchange reserves fell down to such a low level that we could not pay for even a fortnight’s imports and there was also inflationary pressure in internal economy. In such a situation, India had no option except to devaluate the currency. When currency is devalued, the exports become cheaper and the imports become dearer. It encourages exports and discourages imports. It corrects disequilibrium in Current Account. It also encourages capital inflow and discourages capital outflow and thereby corrects deficit in capital Account. Hence, the crisis n BOP account gets corrected.
Q. 4. Explain the following:
(a) To maintain a fixed exchange rate regime, foreign exchange reserves have to deplete.
(b) Fixed exchange rate regime, always lead to a rise in domestic prices.
Ans. (a) This statement will be true in case BOP account is in deficit. If BOP is in deficit, it means demand for foreign currency > supply of foreign currency. It would mean reserves will have to be sold to maintain stability of exchange rate and therefore, the monetary authority’s foreign exchange reserves will reduce. But if BOP is in surplus, it means demand for foreign currency < supply of foreign currency. It would mean reserves will have to be bought to maintain stability of exchange rate and therefore, the monetary authority’s foreign exchange reserves will increase.
(b) This statement is also true only when BOP is in deficit. When there is a deficit, it reduces money supply in the country which in turn reduces the domestic prices. It will encourage exports and discourage imports. It will correct deficit in current account. At the same time, it will also lead to higher rate of interest. It will induce more capital inflows which will correct deficit in capital account.
Q. 5. Select the appropriate alternative and explain.
(a) If the USA fixes its exchange rate, such as four Belgian francs per dollar, then to keep it fixed at the four-francs-per-dollar rate,
(i) Belgium and American exporters and importers must agree to keep their mutual trade in balance.
(ii) Belgium and American exporters and importers must agree not to trade at any other exchange rate.
(iii) The USA Government does the exporting and importing for the United States.
(iv) Both the USA and Belgium Governments do the exporting and importing for their respective countries.
(v) The USA Government must buy and sell US dollar on the foreign exchange market.
Ans. The USA Government must buy and sell US dollar on the foreign exchange market. It is so because under fixed exchange rate regime, when there is a deficit, it reduces money supply in the country which in turn reduces the domestic prices. It will encourage exports and discourage imports. It will correct deficit in current account. On the other hand, when there is a surplus, it increases money supply in the country which in turn increases the domestic prices. It will encourage imports and discourage exports. It will correct surplus in current account.
(b) The Nominal Effective Exchange Rate is:
(i) An unweighted index of several bilateral exchange rates.
(ii) A weighted index of several bilateral exchange rates.
(iii) A lateral exchange rate that is adjusted of inflation.
(iv) A bilateral exchange rate that is unadjusted of inflation.
Ans. (b) NEER (Nominal Effective Exchange Rate) is a weighted index of several bilateral exchange rates. The NEER index is the trade weighted average of the trade flows between crosscurrency movements. When there are many trade partners, NEER is adjusted for the differences in relative prices between trading partners.
(c) The Real Effective Exchange Rate is:
(i) A weighted index of several bilateral exchange rates adjusted for inflation.
(ii) A weighted index of several bilateral exchange rates unadjusted for inflation.
(iii) A bilateral exchange rate that is adjusted of inflation.
(iv) A bilateral exchange rate that is unadjusted of inflation.
Ans. (c) The Real Effective Exchange rate is a weighted index of several bilateral exchange rates adjusted for inflation.
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