NCERT Solutions for Class 12 Economics Part A Chapter 6 Open Economy Macroeconomics

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    1. Differentiate between balance of trade and current account balance.

    Ans.

    Points of Difference Balance of trade Current account balance
    Definition It states the difference between the values of exports and imports of goods of a country during a particular period of time. It states the difference between the values of exports and imports of goods, services and unilateral transfers of a country during a particular period of time.
    Components Export of goods and Import of goods Export and import of goods, export and import of services, unilateral transfers.
    Nature of transactions It is concerned with the transactions related to visible items (i.e., goods) only. It is concerned with the transactions related to visible items (goods) as well as invisible items (services) and unilateral transfers.

    2. What are official reserve transactions? Explain their importance in the balance of payments.

    Ans. The transactions carried out by the monetary authority of a particular country, which can cause changes in official reserves, are termed as Official Reserve Transactions (ORT). Such transactions are carried out through purchase or sale of currency in the exchange market for foreign currencies or other assets. The reserves are also drawn by selling the foreign currencies in exchange market during deficits and foreign currencies are purchased in the case of surplus.
    When the official reserves increases or decreases, it is termed as overall balance of payments surplus or deficit respectively.

    Importance of ORT in balance of payments:

    (i) Purchase of a country’s own currency has to be recorded on the credit side in the balance of payments; whereas, sale of the currency has to be recorded on the debit side.

    (ii) It facilitates the balancing of the deficit and surplus in balance of payments.

    3. Distinguish between the nominal exchange rate and the real exchange rate. If you were to decide whether to buy domestic goods or foreign goods, which rate would be more relevant? Explain.

    Ans. Nominal Exchange Rate is the amount of domestic currency which is required to buy one unit of foreign currency or we can say that it is the price of foreign currency in terms of domestic currency. For example, a rupee- dollar exchange rate of ₹70 means that it costs 70 rupees to buy 1 dollar.
    Real exchange is defined as the ratio of foreign prices to domestic prices. To put it in other words, it measures foreign prices relative to domestic prices.
    $$\text{Real exchange rate =}\frac{{ep}_f}{p}$$
    Where Pf – price level of foreign currency
    P – Price level of domestic currency
    e – Nominal exchange rate
    If, it was to be decided whether to buy domestic goods or foreign goods, then real exchange rate will be more relevant, because real exchange rate considers the inflation differential among the countries and can also be used as an indicator of a country’s competitiveness in the foreign trade. 

    4. Suppose it takes 1.25 yen to buy a rupee, and the price level in Japan is 3 and the price level in India is 1.2. Calculate the real exchange rate between India and Japan (the price of Japanese goods in terms of Indian goods). (Hint: First find out the nominal exchange rate as a price of yen in rupees).

    Ans. Price level in foreign country: (Japan) Pf = 3
    Price level in home country: (India) P = 1.2
    $$\text{Now, real exchange rate}=e\frac{p_{f}}{p}\\\text{Price of 1.25 yen} = 1\space rupee$$
    $$\text{Now, real exchange rate}=\frac{1}{1.25}=\frac{100}{125}=\frac{5}{4}\\\text{Therefore,}=e\frac{4}{5}$$
    $$\text{So, real exchange rate}=e\frac{P_f}{P}\\=\frac{4}{5}×\frac{3}{1.2}=\frac{4}{5}×\frac{30}{12}=2$$
    Therefore, the real exchange rate is 2.

    5. Explain the automatic mechanism by which BoP equilibrium was achieved under the gold standard.

    Ans. In accordance with the gold standard system, gold was taken as a common unit for the purpose of measuring other country’s currency. Thus, the value of a currency was usually defined in terms of gold. In an open market, the exchange rate was also determined by its worth in terms of gold. This was fixed in lower limits and upper limits, and within those limits it was allowed to fluctuate. So, the exchange rate was stabilised under gold standard. Afterwhile, all the countries started maintaining a stock of gold to exchange currency.

    6. How is the exchange rate determined under a flexible exchange rate regime?

    Ans. Under the flexible exchange rate regime, the rate of exchange is determined by the market forces of demand and supply. In other words, the equilibrium rate of exchange is observed at a point where the demand and supply are equal to each other. This can be explained with the help of the given figure:

    DD and SS of CurrencyR

    In the figure, demand is represented on x-axis along with the supply of foreign currency and y-axis represents the exchange rate. DD is the demand curve which is downward slopping, representing an inverse relationship between the rate of exchange and the demand for foreign currency. Whereas, the supply curve is upward sloping, which represents a positive relationship between the rate of exchange and the supply of foreign currency. E is the point of equilibrium rate of exchange, where the demand is equal to the supply of foreign exchange (OR).
    Now , if the exchange rate rises to OR1, then the supply will exceed the demand, forcing the exchange rate to fall back to OR. On the contrary, if the exchange rate falls to OR2, there is a situation of excess demand over supply. Hence, the rate of exchange rises from R2 to R. Hence, the equilibrium exchange rate (OR) is determined by demand and supply of foreign currency.

    7. Differentiate between devaluation and depreciation.

    Ans.

    Points of Difference Balance of trade
    It refers to the fall in the domestic currency under fixed exchange rate. It refers to the decline in the domestic currency under flexible exchange rate.
    It is desired fall. It is undesired fall.
    It promoted export and curbed import It result in fiscal deficit and current account deficit.

    8. Would the central bank need to intervene in a managed floating system? Explain why.

    Ans. Managed floating system is a combination of two systems namely fixed and floating exchange rate systems. Foreign exchange rate is determined by market forces. It makes the government or central bank responsible to intervene when the need for the same arises. The government or the central bank is responsible to moderate the exchange rate movements by purchasing and selling of foreign currency. Thus, to avoid dirty floating, the government often exercises its power to intervene, whenever it is required to do so.

    9. Are the concepts of demand for domestic goods and domestic demand for goods the same?

    Ans. In a system of closed economy, the demand for domestic goods and domestic demand for goods are similar terms and are used interchangeably. However, in an open economy, these two terms have significantly different meanings. Demand for domestic goods includes both the domestic and foreign demand for domestic goods. Whereas, domestic demand for goods includes only the domestic market demand of a country, which is either produced domestically or abroad (foreign countries).

    10. What is the marginal propensity to import when M = 60 + 0.06 Y? What is the relationship between the marginal propensity to import and the aggregate demand function?

    Ans. The amount of extra money spent on imports is known as the marginal propensity to import. The equation given is M = 60 + 0.06Y. Therefore, Marginal propensity to import (m) = 0.06.
    It displays influenced imports, the portion of total imports that depends on revenue. Since the marginal tendency to import has a negative impact on the aggregate demand function, aggregate demand declines as wealth rises. This is so that international commodities, rather than domestic ones, are purchased with the extra money.

    11. Why is the open economy autonomous expenditure multiplier smaller than the closed economy one?

    Ans. In case of a closed economy, equilibrium level of income is given by
          Y = C + cY + I + G
    or   Y – cY = C + I + G
    or   Y (1 – c) = C + I + G
    $$\text{or\space Y}=\frac{C+I+G}{1-c}\\Let (C + I + G) = A_1\\\text{or\space Y}=\frac{A_1}{1-c}\space..Ans$$
    $$\text{or\space Y}=\frac{\varDelta Y}{\varDelta A_1}=\frac{1}{1-c}\space..(1)$$
    In the case of an open economy, equilibrium level of income is given by
         Y = C + cY + I + G + X – M – mY
    or  Y – cY + mY = C + I + G + X
    or  Y (1 – c + m) = C + I + G + X
    $$\text{or\space Y}=\frac{C+I+G+X}{1-c+m}\\\text{Let autonomous expenditure} (A_2) = C + I + G + X$$
    $$\text{or\space Y}=\frac{A_2}{1-c+m}\\\frac{\varDelta Y}{\varDelta A_2}=\frac{1}{1-c+m}\space..(2)$$
    By comparing equations (1) and (2) and the denominators of the given two multipliers, it can be concluded that multiplier in an open economy is smaller as compared to the multiplier in a closed economy, as the denominator in an open economy is greater than the denominator in a closed economy.

    12. Calculate the open economy multiplier with proportional taxes, T = tY, instead of lump-sum taxes as assumed in the text.

    Ans. In the case of proportional tax, the equilibrium income would be:
    Y = C + c(1 – t)Y + I + G + X – M – mY
    Y – c(1 – t)Y + mY = C + I + G + X – M
    Y[1 – c(1 – t) + m] = C + I + G + X – M
    $$Y=\frac{C+I+G+X-M}{1-c(1-t)+m}$$
    Autonomous expenditure (A) = C + I + G + X – M Therefore, open economy multiplier with proportional taxes
    $$Y=\frac{A}{1-c(1-t)+m}\\\frac{\varDelta Y}{\varDelta A}=\frac{A}{1-c(1-t)+m}$$

    13. Suppose C = 40 + 0.8 YD. T = 50, I = 60, G = 40, X = 90, M = 50 + 0.05Y.
    (a) Find the equilibrium income.
    (b) Find the net export balance at equilibrium income.
    (c) What happens to equilibrium income and the net export balance when the government purchases increase from 40 to 50?

    Ans. C = 40 + 0.8YD
    T = 50
    I = 60
    G = 40
    X = 90
    M = 50 + 0.05Y
    (a) Equilibrium level of income
    $$Y=\frac{A}{1-c+m}\\\text{where,}\\A = C – cT + I + G + X – M$$
    $$Y=\frac{C – cT + I + G + X – M}{1-c+m}\\$$
    $$Y=\frac{40 – 0.8×50 + 60 + 40 + 90 – 50}{1-0.75}\\=\frac{140}{0.25}\\Y = 560.$$

    (b) Net exports at equilibrium income
    NX = X – M – mY
    = 90 – 50 – (0.05 × 560)
    = 40 – 28 = 12

    (c) When G increase from 40 to 50, Equilibrium income
    $$Y=\frac{C – cT + I + G + X – M}{1-c+m}$$$$Y=\frac{40 – 0.8×50 + 60 + 40 + 90 – 50}{1-0.8+0.05}$$$$Y=\frac{40 – 40 + 60 +50+90-50}{0.25}$$$$\frac{150}{0.25}=600$$

    Net export balance at equilibrium income
    NX = X – (M – mY)
    = 90 – 50 – (0.05 × 600)
    = 40 – 30 = 10.

    14. In the above example, if exports change to X = 100, find the change in equilibrium income and the net export balance.
    Ans.
    C = 40 + 0.8 YD
    T = 50
    I = 60
    G = 40
    X = 100
    M = 50 + 0.05 Y
    Equilibrium income
    $$Y=\frac{A}{1-c+m}$$$$Y=\frac{C – cT + I + G + X – M}{1-c+m}$$$$Y=\frac{40 – 0.8×50 + 60 + 40 + 100 – 50}{1-0.8+0.05}$$$$Y=\frac{40 – 40 + 60 +40+100-50}{0.25}$$$$\frac{150}{0.25}=600$$

    Net export balance
    NX = X – M – 0.05Y
    = 100 – 50 – (0.05 × 600)
    = 50 – (0.05 × 600)
    = 50 – 30 = 20.

    15. Suppose the exchange rate between the Rupee and the dollar was ₹30 = 1$ is the year 2010. Suppose the prices have doubled in India over 20 years while they have remained fixed in USA. What, according to the purchasing power parity theory will be the exchange rate between dollar and rupee in the year 2030.

    Ans. In the year 2010, the exchange rate between the Indian rupee and the US dollar was ₹30 for $1, which means that a good that cost $1 in the USA would cost ₹30 in India. Over the next 20 years, the price of the same good in India doubled to ₹60 while it remained fixed at $1 in the USA. To make the prices of the good equivalent, ₹60 must be worth $1. This implies that the value of the Indian rupee has decreased over time, which is known as depreciation.
    In summary, the increase in prices in India while prices remain fixed in the USA leads to a decrease in the value of the Indian rupee, as reflected in the higher exchange rate required to make the prices of goods equivalent between the two countries.

    16. If inflation is higher in country A than in Country B, and the exchange rate between the two countries is fixed, what is likely to happen to the trade balance between the two countries?

    Ans. Country A has a higher inflation than country B. As, the given exchange rate is fixed, it is beneficial for country B to export goods to country A. Similarly, it is beneficial for country A to import goods from country B. On the contrary it would be expensive for country A to export goods to country B. Therefore, country A will have to suffer from a situation of trade deficit as it will import more goods as compared to exports, from country B. Country B will import less goods instead of exports, from country A. Hence, there will be a trade surplus in country B.

    17. Should a current account deficit be a cause for alarm? Explain.

    Ans. Current account deficit is expressed as the excess of total import of goods, services and transfers over total exports of goods, services and transfers. This situation can make a country a debtor to the rest of the world. But, this should not be necessarily treated as a cause for alarm because countries might be running in deficits (current account) to increase productivity and exports in future. Also, more investments will help in building capital stock, which in future will make the situation better by increasing the output.

    18. Suppose C = 100 + 0.75Y D, I = 500, G = 750, taxes are 20 per cent of income, X = 150, M = 100 + 0.2 Y. Calculate equilibrium income, the budget deficit or surplus and the trade deficit or surplus.

    Ans. C = 100 + 0.75 YD
    I = 500
    G = 750
    X = 150
    M = 100 + 0.2 Y
    Equilibrium income
    (Y) = C + c(Y – T) + I + G + X – M – mY
    or Y = 100 + 0.75 (Y – 0.20Y) + 500 + 750 + 150 – 100 – 0.2Y
    or Y = 1400 + 0.75 (0.8 Y) – 0.2 Y
    or Y = 1400 + 0.6 Y – 0.2 Y
    or Y = 1400 + 0.4 Y
    or 0.6 Y = 1400
    Y = 2333.33
    Government expenditure = 750
    Government receipts (taxes)
    $$2333.33 ×\frac{20}{100}\\=466.6$$
    Since,
    government expenditure > government receipts
    Its shows, the government is having a budget deficit
    NX = X – M – MY
    = 150 – 100 – (0.2 × 2333.33)
    = 150 – 100 – 466.66
    = 150 – 566.66
    = – 416.66
    Since NX is negative, it implies trade deficit.

    19. Discuss some of the exchange rate arrangements that countries have entered into to bring about stability in their external accounts.

    Ans. In order to combine the two extreme positions, `fixed’ and ‘flexible’, the following exchange rate arrangements are often used by governments to bring stability in external accounts:

    (i) Wider Bands: A system that allows variations in fixed exchange rate is termed as wider bands. It permits only 10% variation between the currencies of any given two countries. For example, by depreciating the currency, a country can improve its balance of payments (BoP) deficit which result in increase in demand for domestic goods due to the increase in purchasing power of other currencies. This further leads to an increase in exports, thereby improving the BoP.

    (ii) Crawling Peg: Crawling peg system allows to make continuous and regular adjustments in the prevailing exchange rate. Only 1% of variation can be made at a time.

    (iii) Managed floating: Managed floating is a scheme as per which, the government can intervene to change or adjust the exchange rate as and when it is required. There is no specific limit of variation unlike crawling peg and wider bands.

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