From UPSC IAS Examination point of view, the Questions based on Indian Economy are very important. The UPSC IAS aspirants must be aware of the every perspective of Indian Economy either it is static or dynamic.
1. Consider the following statements:
1. Trade in services denoted as invisible trade because they are not seen to cross national borders.
2. Total foreign trade (exports +imports) as a proportion of GDP is a common measure of the degree of openness of an economy.
Select the correct answer using the code given below.
a. 1 only
b. 2 only
c. Both 1 and 2
d. Neither 1 nor 2
In Balance of Payment, the current account records exports and imports in goods and services and transfer payments. The first two items BoP record exports and imports of goods. The third item gives the trade balance which is obtained by subtracting imports of goods from the exports of goods. When exports exceed imports, there is a trade surplus and when imports exceed exports there is a trade deficit.
Trade in services denoted as invisible trade (because they are not seen to cross national borders) includes both factor income (net income from compensation of employees and net investment income, the latter equals, the interest, profits and dividends on our assets abroad minus the income foreigners earn on assets they own in India) and net non-factor income (shipping, banking, insurance, tourism, software services, etc.).
2. Which of the following statements is incorrect regarding the exchange rate?
a. If the real exchange rate is equal to zero, currencies are at purchasing power parity
b. The real exchange rate is often taken as a measure of a country’s international competitiveness.
c. The price of one currency in terms of the other is known as the exchange rate.
d. Real exchange rate – the ratio of foreign to domestic prices, measured in the same currency.
The price of one currency in terms of the other is known as the exchange rate. Since there is symmetry between the two currencies, the exchange rate may be defined in one of the two ways. First, as the amount of domestic currency required to buy one unit of foreign currency, i.e. a rupee-dollar exchange rate of Rs 50 means that it costs Rs 50 to buy one dollar, and second, as the cost in foreign currency of purchasing one unit of domestic currency. In the above case, we would say that it costs 2 cents to buy a rupee. The practice in economic literature, however, is to use the former definition – as the price of foreign currency in terms of domestic currency. This is the bilateral nominal exchange rate – bilateral in the sense that they are exchange rates for one currency against another and they are nominal because they quote the exchange rate in money terms, i.e. so many rupees per dollar or per pound.
However, returning to our example, if one wants to plan a trip to London, she needs to know how expensive British goods are relative to goods at home. The measure that captures this is the real exchange rate – the ratio of foreign to domestic prices, measured in the same currency.
Real exchange rate = P/ePf
Where P and Pf are the price levels here and abroad, respectively and e is the rupee price of foreign exchange (the nominal exchange rate). The numerator expresses prices abroad measured in rupees; the denominator gives the domestic price level measured in rupees, so the real exchange rate measures prices abroad relative to those at home.
3. Which of the following statements is incorrect regarding the Exchange Rate Management?
(a) The Bretton Woods Conference was held in 1944 in Canada.
(b) Silver supplemented gold introducing ‘bimetallism’.
(c) Gold standard was the epitome of the fixed exchange rate system
(d) The Gold Standard: 1870 to the outbreak of the First World War in 1914
The Bretton Woods System: The Bretton Woods Conference held in 1944 set up the International Monetary Fund (IMF) and the World Bank and re-established a system of fixed exchange rates. This was different from the international gold standard in the choice of the asset in which national currencies would be convertible. A two-tier system of convertibility was established at the centre of which was the dollar.
The US monetary authorities guaranteed the convertibility of the dollar into gold at the fixed price of $35 per ounce of gold. The second-tier of the system was the commitment of monetary authority of each IMF member participating in the system to convert their currency into dollars at a fixed price. The latter was called the official exchange rate. For instance, if French francs could be exchanged for dollars at roughly 5 francs per dollar, the dollars could then be exchanged for gold at $35 per ounce, which fixed the value of the franc at 175 francs per ounce of gold (5 francs per dollar times 35 dollars per ounce). A change in exchange rates was to be permitted only in case of a ‘fundamental disequilibrium’ in a nation’s BoP – which came to mean a chronic deficit in the BoP of sizeable proportions.
4. What does pegged exchange rate system mean?
a. The exchange rate is pegged at a particular level
b. The exchange rate is determined by the forces of market demand and supply
c. The exchange rate is fixed by bank consortium
d. The exchange rate is fixed by Govt together with private players.
Prior to the breakdown of the Bretton Woods system in the early 1970s, most countries had fixed or what is called pegged exchange rate system, in which the exchange rate is pegged at a particular level. Sometimes, a distinction is made between the fixed and pegged exchange rates.
A pegged exchange rate system may, as long as the exchange rate is not changed, and is not expected to change, display the same characteristics. However, there is another option open to the government – it may change the exchange rate. Devaluation is said to occur when the exchange rate is increased by social action under a pegged exchange rate system. The opposite of devaluation is a revaluation. Or, the government may choose to leave the exchange rate unchanged and deal with the BoP problem by the use of monetary and fiscal policy.
Most governments change the exchange rate very infrequently. So, sometimes you can use the terms fixed and pegged exchange rates interchangeably to denote an exchange rate regime where the exchange rate is set by government decisions and maintained by government actions.
5. Devaluation is said to occur when the exchange rate is ______?
(c) Kept constant
(d)None of these
Devaluation is said to occur when the exchange rate is increased by social action under a pegged exchange rate system. The opposite of devaluation is a revaluation. Or, the government may choose to leave the exchange rate unchanged and deal with the BoP problem by the use of monetary and fiscal policy.
6. With reference to Exchange rate, consider the following statements:
1. Managed floating exchange rate system is a mixture of a flexible exchange rate system and a fixed rate system.
2. In dirty floating, 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.
Select the correct answer using the code given below.
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2
Without any formal international agreement, the world has moved on to what can be best described as a managed floating exchange rate system. It is a mixture of a flexible exchange rate system (the float part) and a fixed rate system (the managed part).
Under this system, also called dirty floating, 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. Official reserve transactions are, therefore, not equal to zero.
7. Which of the following Institutions are “The Bretton Woods System”?
(a)IMF and WTO
(b)IMF and World Bank
(c)WTO and World Bank
(d)IBRD and IDA
The Bretton Woods Conference held in 1944 set up the International Monetary Fund (IMF) and the World Bank and re-established a system of fixed exchange rates.
8. The Smithsonian Agreement of 1971 is related to?
a. Widening the permissible band of the exchange rates to 2.5 per cent above or below the new ‘central rates’.
b. Tackle shortage of liquidity during the Great Depression
c. Moving from fixed to floating exchange rate
d. Bop crisis faced by countries after fall of the Bretton Woods System
The ‘Smithsonian Agreement’ in 1971, which widened the permissible band of movements of the exchange rates to 2.5 per cent above or below the new ‘central rates’ with the hope of reducing pressure on deficit countries, lasted only 14 months. The developed market economies led by the United Kingdom and soon followed by Switzerland and then Japan began to adopt floating exchange rates in the early 1970s.
In 1976, revision of IMF Articles allowed countries to choose whether to float their currencies or to peg them (to a single currency, a basket of currencies, or to the SDR). There are no rules governing pegged rates and no de facto supervision of floating exchange rates.
9. With reference to SDR, consider the following statement:
1. ‘Reserve asset’ created under the control of the IMF
2. At present, it is calculated daily as the weighted sum of the values in dollars of four currencies (euro, dollar, Japanese yen, and pound sterling)
3. Special Drawing Rights (SDRs) also known as ‘paper gold’
Which of the statements given above is/are correct?
(a) 1 and 2 only
(b) 2 only
(c) 1, 2 and 3
(d) 2 and 3 only
In 1967, gold was displaced by creating the Special Drawing Rights (SDRs), also known as ‘paper gold’, in the IMF with the intention of increasing the stock of international reserves. Originally defined in terms of gold, with 35 SDRs being equal to one ounce of gold (the dollar-gold rate of the Bretton Woods system), it has been redefined several times since 1974.
At present, it is calculated daily as the weighted sum of the values in dollars of four currencies (euro, dollar, Japanese yen, and pound sterling) of the five countries (France, Germany, Japan, the UK and the US). It derives its strength from IMF members being willing to use it as a reserve currency and use it as a means of payment between central banks to exchange for national currencies. The original instalments of SDRs were distributed to member countries according to their quota in the Fund (the quota was broadly related to the country’s economic importance as indicated by the value of its international trade).
10. With mines not producing enough gold, __________ helped to economise on gold.
(a) Fractional reserve banking (Paper currency was not entirely backed by gold)
(b) Gold Standard
(c) fixed exchange rate system
(d) Silver standard
Several crises 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 per cent per year, the gold supply would have to increase by 4 per cent per year to keep prices stable. With mines not producing this much gold, price levels were falling all over the world in the late nineteenth century, giving rise to social unrest. For a period, silver supplemented gold introducing ‘bimetallism’. Also, fractional reserve banking helped to economise on gold. Paper currency was not entirely backed by gold; typically countries held one-fourth gold against its paper currency.
Another way of economising on gold was the gold exchange standard which was adopted by many countries which kept their money exchangeable at fixed prices with respect to gold but held little or no gold. Instead of gold, they held the currency of some large country (the United States or the United Kingdom) which was on the gold standard. All these and the discovery of gold in Klondike and South Africa helped keep deflation at bay till 1929. Some economic historians attribute the Great Depression to this shortage of liquidity. During 1914-45, there was no maintained universal system but this period saw both a brief return to the gold standard and a period of flexible exchange rates.