CHAPTER – 6

OPEN ECONOMY

I Choose the correct answer

1. The consumers and producers can choose between domestic and foreign goods, this
market linkage is called
a) Financial Market linkage c) Labour market linkage
b) Output market linkage d) None of the above
Ans: (b) Output market linkage.
2. The exchange rate is determined by the market forces of demand and supply is called
as
a) Fixed exchange rate c) Flexible exchange rate
b) Dirty floating exchange rate d) None of the above
Ans: (c) Flexible exchange rate
3. The balance of payments (BOP) record these transactions between residents and with
the rest of the world
a) Goods b) Services c) Assets d) All of the above
Ans: (d) All of the above
4. The rate at which the price of one currency in terms of foreign currency is called
a) Exchange control c) Foreign exchange rate
b) Interest rate d) None of the above.
Ans: (c) Foreign exchange rate
5. In this standard all currencies were defined in terms of gold
a) Metal standard b) silver standard c) Gold standard d) None of the
above
Ans: (c) Gold Standard

II Fill in the blanks:

1. …………is the record of trade in goods and services and transfer payments
Ans: Current Account
2. ………account records all international transactions of assets.
Ans: Capital
3. The price of foreign currency in terms of domestic currency has increased and this is
called …………of domestic currency.
Ans: Depreciation
4. …………is a mixture of a flexible and fixed exchange rate system.
Ans: Managed floating exchange rate
5. The Bretton Woods conference held in the year ………….
Ans: 1944.

III Match the following:

A B
 1. SDR a) Dirty floating
2. Balance of payment b) Flexible exchange rate
3. Balance of trade c) Paper gold
4. Floating exchange rate d) Trade in goods
5. Managed floating e) Trade in goods and services
Ans: 1 – c; 2 – e; 3 - d; 4 – b; 5 – a;

IV Answer the following questions in a sentence/word.

1. What do you mean by open economy?

Ans: An open economy is one which interacts with rest of the world through various
channels.
2. What is balance of payment?
Ans: The balance of payments is the record of the transactions in goods, services and
assets between residents of a country with the rest of the world for a specified period
of time i.e., a year.
3. What is balance of trade?
Ans: Balance of trade is the difference between the value of exports and value of
imports of goods of a country in a given period of time.
4. What do you mean by fixed exchange rate?
Ans: Fixed exchange rate is an exchange rate between the currencies of two or more
countries that is fixed at some level. Under this system, the government fixes the
exchange rate at a particular level.
5. Give the meaning of official reserve sale.
Ans: When the Reserve Bank of India sells foreign exchange when there is deficit
balance of payments, it is called official reserve sale.
6. Give the meaning of managed floating.
Ans: The managed floating exchange rate system is the mixture of a flexible
exchange rate system and a fixed exchange rate system.
Here, the central banks intervene to buy and sell foreign currencies in an
attempt to moderate exchange rate movements whenever they feel that such actions
are appropriate.
V Answer the following questions in 4 sentences.
1. Mention the three linkages of open economy.
Ans: The three linkages of open economy are as follows:
 Output market linkage
 Financial Market linkage
 Labour market linkage.
2. What is the difference between current account and capital account?
Ans: The difference between current account and capital account is as follows:

Current account Capital account

 It is the record of trade in goods  It is the record of all international
and services and transfer transactions of assets.
payments.  It includes money, stocks, bonds,
 It consists of factor and non-factor government debt etc.
 incomes apart from gifts,
remittances and grants.
3. When do surplus and deficit arises in capital account?
Ans: Surplus in capital account arises when the capital inflows are greater than
capital outflows.
Deficit in capital account arises when capital inflows are lesser than capital
outflows.
4. Write the meaning of balanced, surplus and deficit BOT.
Ans: Balance of trade is said to be in balance when exports of goods are equal to
the imports of goods i.e., balanced balance of trade.
Surplus balance of trade arises if country’s exports of goods are more than its
imports.
Deficit balance of trade arises if a country’s imports of goods are more than its
exports.
5. Why do people demand foreign exchange?
Ans: People demand foreign exchange rate because of the following reasons:
 To purchase goods and services from other countries.
 To send gifts abroad
 To purchase financial assets abroad.
6. What is foreign exchange rate?
Ans: Foreign exchange rate is the price of one currency in terms of another
currency. It links the currencies of different countries and enables comparison of
international costs and prices.
For example, if we need to pay Rs.68 for 1 dollar, then the exchange rate is
Rs.68 per dollar.
7. Differentiate between depreciation and devaluation.
Ans: The difference between Depreciation and Devaluation is as follows:

Depreciation Devaluation
 Here the price of foreign currency  Here, the government deliberately
in terms of domestic currency makes the domestic currency
increases. cheaper by increasing exchange
 It happens because of market rate.
forces i.e., demand for foreign  It is a deliberate action of
exchange and supply of foreign government.
exchange.

VI Answer the following questions in 12 sentences.

1. Write a note on balance of trade.

Ans: Balance of trade is the difference between the value of exports and value
of imports of goods of a country in a given period of time. Export of goods is
entered as a credit item in balance of trade. Import of goods is entered as a
debit item in balance of trade. It is also called as Trade balance.
Balance of trade is said to be in balance when exports of goods are equal to the
imports of goods i.e., balanced balance of trade.
 Surplus balance of trade arises if country’s exports of goods are more than its
imports.
Deficit balance of trade arises if a country’s imports of goods are more than its
exports.
Balance of trade is narrow concept and it may not show the international
economic position of an economy. It gives partial picture of international transactions
and it is less reliable. It does not include net invisibles i.e., the difference between the
value of exports and value of imports of invisibles (services) of a country in a given
period of time.
2. Write the chart of components of current account.
Ans: The chart which consists of different components of current account can
be drawn as follows:

Current Account

Trade in goods Trade in services Transfer Payments

Export ofImport of Net factor Net non-factorGifts, remittances

Goods Goods Income Income Grants

Net income
From Shipping, banking
Compensationinsurance, tourism
of employeessoftware service etc.

Net investment
income

3. Write the chart of components of capital account.

Ans: The chart which consists of different components of capital account can
be drawn as follows:
Capital Account

Investments External Borrowings External Assistance

Direct Portfolio External Govt. aid, Inter

InvestmenInvestment commercial governmental,
Borrowings multilateral and
FDI, Equity FII, Offshore short term debt Bilateral loans
Reinvested funds
Earnings &
Other direct
Capital flows

FDI – Foreign Direct Investment; FII – Foreign Institutional Investments

4. Briefly explain the effect of an increase in demand for imports in the

foreign exchange market with the help of a diagram.
Ans: Foreign exchange market is the market in which national currencies are
traded for one another. The major participants in the foreign exchange market
are commercial banks, foreign exchange brokers and other authorized dealers
and monetary authorities.
Foreign exchange rate is the price of one currency in terms of another
currency. 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.
The flexible exchange rate is determined by the market forces of
demand and supply. Here, the exchange rate is determined at that point where
the demand curve intersects with the supply curve.
If the demand for foreign goods and services increases, the demand
curve shifts upward and right to the original demand curve. This can be
graphically represented as follows:

The increase in demand for imports, results in a change in the exchange rate.
The initial exchange rate is E1 = 60, which means that we need to exchange
Rs.60 for one dollar. At the new equilibrium, the exchange rate becomes
E2=70, which means that we need to pay more rupees for a dollar.
The increase in the price of dollars due to rise in demand for imports
indicates that the value of rupees in terms of dollars has fallen and the value of
dollar in terms of rupees has increased.
5. Explain the merits and demerits of flexible and fixed exchange rate
system.
Ans:
Flexible exchange rate: The flexible exchange rate is determined by the
market forces of demand and supply. Here, the exchange rate is determined at
that point where the demand curve intersects with the supply curve.

Merits of Flexible exchange rate:

  The flexible exchange rate system gives the government more
flexibility and they do not need to maintain large stocks of foreign
exchange reserves.
 The movements in the exchange rate automatically take care of the
surpluses and deficits in the Balance of payments.
Demerits of Flexible Exchange rate:
 It is subject to international market fluctuations as the rate of exchange
is determined by market forces demand and supply.
 It may lead to uncertainties in foreign exchange market due to
speculations.
Fixed exchange rate:Under this exchange rate system, the Government fixes
the exchange rate at a particular level. Here, the central monetary authority or
the Government decides the exchange rate in accordance with the international
market requirements.
Merits of Fixed Exchange rate:
 There is more credibility that the government will be able to maintain
the exchange rate at the level specified.
 In case of deficit balance of payments, the governments will interfere
to take care of the gap by use of its official reserves.

Demerits of Fixed exchange rate:

 If the foreign exchange reserves are inadequate, people would begin to

doubt the ability of the government.
 There may be aggressive buying of one currency forcing the
government to devalue, so there may be speculative attack on a
currency.

VII Answer the following questions in 20 sentences

1. Write a note on balance of payment.

Ans: The balance of payments is the record of the transactions in goods, services and
assets between residents of a country with the rest of the world for a specified time
period i.e., a year. The balance of payments consists of two accounts viz.,
 Current Account
 Capital Account.
Current Account:It is the record of trade in goods and services and transfer
payments. The main components of current account are trade in goods i.e., exports
and imports of goods. The Trade in services includes the factor income and non-factor
income transactions. Transfer payments are the receipts which the residents of a
country get for free without having to provide any goods or services in return. They
consists of gifts, remittances and grants. They could be given by the government or by
private citizens living abroad.
Current account is in balance when receipts on current account are equal to the
payments on the current account. A surplus current account means that the nation is a
 lender to other countries and a deficit current account means that the nation is a
borrower from other countries.
Capital Account: It is the record of all international transactions of assets. An asset is
any one of the forms in which wealth can be held.
For example, stocks, bonds, government debt etc. Purchase of assets is a debit item
on the capital account. If an Indian buys a UK car company it enters capital account
transactions as a debit item. On the other hand, sale of assets like sale of share of an
Indian company to a USA customer is a credit item on the capital account.
The capital account mainly consists of foreign direct investment, foreign
institutional investments, external borrowings and assistance.
The capital account will be in balance when capital inflows are equal to capital
outflows. Surplus in capital account arises when capital inflows are greater than
capital outflows and deficit in capital account arises when capital inflows are lesser
than capital outflows.
(Capital inflows: Loans from abroad, sale of assets or shares in foreign companies)
(Capital outflows: Repayment of loans, purchase of assets or shares in foreign
countries)

2. Briefly explain the foreign exchange market with fixed exchange rates with the
help of a diagram.
Ans: Under fixed exchange rate system, the government decides the exchange rate at
a particular level. The foreign exchange market with fixed exchange rates can be
explained with the help of following diagram:

Rs/D S

E1 A B

E e

E2

O Dollars
In the above diagram, the market determined exchange rate is e where demand and supply
intersect. However, if the government wants to encourage exports for which it needs to make
rupee cheaper for foreigners it would do so by fixing a higher exchange rate say, Rs.70 per
dollar from the current exchange rate of Rs.65 per dollar. Thus, the new exchange rate set by
the government is E1 where E1 is greater than E. At this exchange rate, supply of dollars
exceeds the demand for dollars. The RBI intervenes to purchase the dollars for rupees in the
foreign exchange market in order to absorb this excess supply which has been marked as AB
in the diagram.

Thus, by interfering, the government can maintain any exchange rate in the
economy. If the government wants to set an exchange rate at a level E2 there would be an
excess demand for dollars, the government would have to withdraw dollars from its past
holds of dollar. If the government fails to do so, it will encourage black market transactions.

3. Write a short note on the gold standard.

Ans: The gold standard was prevailing from 1870 to 1914. All currencies were
defined in terms of gold; indeed some were actually made of gold. Each participant
country committed to guarantee the free convertibility of its currency into gold at a
fixed price. That means a domestic currency which was free convertible at fixed price
into another asset acceptable in international payments. This also made it possible for
each currency to be convertible into all others at a fixed price.
Exchange rates were determined by its worth in terms of gold. For example, if one
unit currency A was worth one gram of gold, one unit of currency B was worth two
grams of gold, currency B would be worth twice as much as currency A. Economic
agents could directly convert one unit of currency B into two units of currency A,
without having to first buy gold and then sell it. The rates would fluctuate between an
upper and a lower limit, these limits being set by the costs of melting, shipping and
recoining between the two currencies. To maintain the official parity of each country
needed an adequate stock of gold reserves. All countries on the gold standard had
stable exchange rates.
Many problems caused the gold standard to break down periodically. Moreover,
world price levels were at the mercy of gold discoveries. This can be explained by
looking at the crude quantity theory of money, M=kPY, according to which, if output
(GNP) increased at the rate of 4 percent per year, the gold supply would have to
increase by 4 percent per year to keep prices stable. With mines not producing this
much gold, price levels were falling all over the world in the late 19th century, giving
rise to social unrest. For a period, silver supplemented gold introducing ‘bi-
metallism’. Also, fractional reserve banking helped to economize on gold. Paper
currency was not entirely backed by gold; typically countries held one-fourth gold
against its paper currency.

VIII Assignment and project oriented questions

1.Name the currencies of any five countries of the following
USA, UK, Germany, Japan, China, Argentina, UAE, Bangladesh, Russia
Ans:

Countries Currency
USA US dollars
UK British Pound
Germany Euro
Japan Japanese Yen
China Chinese yuan
Argentina Argentine peso
UAE UAE dirham
Bangladesh Bangladeshi taka
Russia Russian Ruble

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