CBSE Class 12 Economics NCERT Solutions Chapter 9: Foreign Exchange Rate

Under a flexible exchange rate regime, the exchange rate is determined in the foreign exchange market by the forces of demand and supply. The equilibrium exchange rate is established at the point where the demand for foreign exchange equals its supply.

Let's consider the exchange rate between the Indian Rupee (INR) and the US Dollar (USD). In this scenario, both countries operate under a flexible exchange rate system, meaning the value of each currency relative to the other is determined by market forces.

The diagram illustrates this determination:

• The vertical axis represents the price (exchange rate) in terms of the domestic currency (e.g., how many rupees are needed to buy one US dollar).
• The horizontal axis measures the quantity of foreign exchange (US Dollars) demanded or supplied.

Demand Curve [D$]: The demand curve for foreign exchange is downward sloping. This indicates that as the exchange rate (price of foreign currency) increases, the quantity of foreign exchange demanded decreases. This is because a higher exchange rate makes foreign goods more expensive in terms of the domestic currency, leading to a reduction in imports and thus a lower demand for foreign exchange.

Supply Curve [S$]: The supply curve for foreign exchange is upward sloping. This signifies that as the exchange rate increases, the supply of foreign exchange also increases. When the domestic currency depreciates (exchange rate rises), domestic goods become cheaper for foreigners, boosting exports. Increased exports lead to a greater inflow of foreign currency, thus increasing its supply.

Equilibrium: The intersection of the demand curve [D$] and the supply curve [S$] determines the equilibrium exchange rate (OP$) and the equilibrium quantity [OQ$] of foreign currency (US Dollars) traded in the market.

Diagram Representation:

Rate of Exchange (P$) S$ P$ D$ 0 Q$ Quantity demanded or supplied [US Dollar]

Devaluation and depreciation both refer to a fall in the value of a country's domestic currency in terms of foreign currencies, but they differ significantly in their causes and the exchange rate systems under which they occur.

No, the concepts of 'demand for domestic goods' and 'domestic demand for goods' are not the same; they represent distinct economic ideas:

1. Demand for Domestic Goods: This refers to the total demand for goods and services produced within a country. This demand can come from both domestic consumers and residents, as well as from foreign buyers (exports).
2. Domestic Demand for Goods: This refers specifically to the demand for goods and services by the residents of a country, irrespective of where the goods are produced. This demand can be met by domestically produced goods or by imported goods.

Therefore, while there is an overlap, the scope of 'demand for domestic goods' includes exports, whereas 'domestic demand for goods' focuses on the consumption needs within the country, which may be satisfied by imports.

Yes, the central bank would need to intervene in a managed floating system. Here's why:

1. Objective of Stability: A managed floating system allows the exchange rate to fluctuate based on market forces, but the central bank retains the freedom to intervene to manage these fluctuations. The primary reason for intervention is to maintain stability in the exchange rate and prevent excessive volatility that could harm the economy.
2. Limited Freedom: While the central bank has some freedom to influence the exchange rate, this freedom is often limited. For instance, a country might be allowed by international agreements (like those with the IMF) to allow its currency's value to change within a certain band or by a specific percentage (e.g., not more than 10%) without needing explicit permission for minor adjustments.
3. Preventing Misalignment: Intervention helps prevent the exchange rate from deviating significantly from its fundamental economic value, which could lead to imbalances in trade or capital flows. The central bank might buy or sell foreign currency to influence the rate.

In essence, a managed float combines elements of both fixed and flexible exchange rate systems, requiring central bank oversight to ensure orderly market conditions.