Class 12 Economics Chapter 9 Foreign Exchange Rate
Chapter 9 of Class 12 Economics, titled \”Foreign Exchange Rate,\” introduces students to the concept of currency exchange between countries and its impact on the economy. This chapter explains how exchange rates are determined, the functioning of foreign exchange markets, and the distinction between fixed and flexible exchange rate systems.
What You Will Learn in Chapter 9 – Foreign Exchange Rate
This chapter helps students understand the mechanism behind currency conversion, the demand and supply of foreign exchange, and how international transactions are facilitated. It’s vital for grasping the fundamentals of global trade and macroeconomic policy in an open economy.
Key Topics Covered:
1. Meaning of Foreign Exchange Rate
The rate at which one currency is exchanged for another.
Example: If $1 = ₹80, then the exchange rate is ₹80 per US dollar.
2. Types of Exchange Rate Systems
Fixed Exchange Rate: Set and maintained by the government.
Flexible Exchange Rate: Determined by market forces of demand and supply.
Managed Floating: A blend of fixed and flexible exchange rate systems.
3. Determination of Foreign Exchange Rate
In a flexible system, the rate is determined by:
Demand for foreign exchange (imports, investment abroad).
Supply of foreign exchange (exports, foreign investments into the country).
4. Demand for Foreign Exchange
To pay for imports.
To invest in foreign assets.
To remit funds abroad.
5. Supply of Foreign Exchange
Earnings from exports.
Foreign investments.
Remittances from abroad.
6. Diagrammatic Explanation
Graphical representation of demand-supply equilibrium of foreign exchange.
Shows how exchange rate is determined at the point where demand equals supply.
7. Appreciation and Depreciation of Currency
Appreciation: When domestic currency becomes stronger (e.g., ₹80/$ → ₹75/$).
Depreciation: When domestic currency becomes weaker (e.g., ₹75/$ → ₹80/$).
Concept Table – Currency Fluctuations
| Term | Meaning | Effect |
|---|---|---|
| Appreciation | Increase in value of domestic currency | Imports cheaper, exports costlier |
| Depreciation | Decrease in value of domestic currency | Exports cheaper, imports costlier |
NCERT Solutions for Chapter 9 – Foreign Exchange Rate
Intext Questions:
Covers basic definitions and concepts such as:
Foreign exchange and its importance.
Difference between fixed and flexible exchange rate systems.
Exercise Questions (Q1–Q9):
Includes detailed answers on:
How exchange rate is determined.
Graph-based explanations.
Currency appreciation/depreciation impact.
Real-life scenarios and calculation-based questions.
Download Chapter 9 Solutions PDF – Foreign Exchange Rate
Get access to our free, comprehensive PDF containing:
All NCERT intext and exercise solutions.
Clear definitions and formula-based explanations.
Visual illustrations of demand-supply graphs.
CBSE-focused long and short answers.
Highlights of Our NCERT Solutions:
Conceptual clarity with real-world applications.
Simple language and clear structure.
Board-exam-ready answers and solved examples.
Easy-to-remember key points and definitions.
Recommended Preparation Tips:
Revise the difference between fixed and flexible exchange rate systems.
Practice diagram-based questions on demand and supply of foreign exchange.
Learn the impact of currency appreciation/depreciation with examples.
Understand terms like Balance of Payments, FOREX market, and capital account.
Solve NCERT and additional practice numericals.
Additional Study Resources:
Flashcards for key terms (Appreciation, Depreciation, BOP).
Diagram practice sheets.
Previous year CBSE questions on exchange rates.
Online mock tests with exchange rate-based case studies.
Mastering Chapter 9 – Foreign Exchange Rate
Understanding foreign exchange rate systems is crucial for analyzing how countries interact economically on the global stage. Whether it\’s international trade, tourism, or investment flows, this chapter gives students a solid grasp of currency markets and policy implications.
Perfect for CBSE Board Exams and competitive entrance tests like CUET, this chapter lays the foundation for open economy macroeconomics and international finance.
NCERT Solutions for Class 12 Economics Chapter 9 Foreign Exchange Rate
NCERT Textbook Questions Solved – Class 12 Macro Economics
Question 1. How is exchange rate determined under a flexible exchange rate regime? [6 Marks]
Or How is foreign exchange rate determined? Explain with diagram.
Or How is exchange rate determined in a foreign exchange market? [CBSE/AI 2004, 2006, 2013]
Answer:
Under a flexible exchange rate system, the exchange rate is determined by the forces of demand and supply of foreign exchange in the market. There is no government intervention in determining the rate.
Let us assume two countries — India and the USA. Their currencies are the Indian Rupee (₹) and the US Dollar ($), respectively. In a flexible exchange regime, the value of the rupee in terms of the dollar is decided by how much dollars are demanded and supplied in the foreign exchange market.
Key points:
- The demand for foreign exchange (US $) arises mainly due to India’s imports, foreign travel, education abroad, etc.
- The supply of foreign exchange comes from exports, remittances, and foreign investments.
In the foreign exchange market:
- The demand curve (D$) slopes downward, indicating that as the exchange rate (₹ per $) rises, fewer dollars are demanded.
- The supply curve (S$) slopes upward, indicating that at higher exchange rates, more dollars are supplied as Indian goods become cheaper for foreigners, boosting exports.
The intersection of the demand and supply curves determines the equilibrium exchange rate (OP$) and the corresponding quantity of foreign exchange (OQ$).
Diagram Explanation:
The vertical axis represents the exchange rate (₹ per $), and the horizontal axis represents the quantity of foreign exchange.
- At equilibrium, the quantity of dollars demanded equals the quantity supplied.
- This equilibrium point determines the market exchange rate.
(Note: You can add a custom diagram here if required in your WordPress post using an image block.)
Question 2. Differentiate between devaluation and depreciation. [3 Marks]
Answer:
| Basis | Devaluation | Depreciation |
|---|---|---|
| Meaning | Intentional reduction in the value of a currency by the government under fixed exchange rate. | Fall in value of a currency due to market forces under flexible exchange rate. |
| System | Occurs under fixed exchange rate system. | Occurs under flexible exchange rate system. |
| Cause | Caused by government decision. | Caused by changes in demand and supply in foreign exchange market. |
Question 3. Are the concepts of demand for domestic goods and domestic demand for goods the same? [3 Marks]
Answer:
No, both concepts are different:
- Demand for domestic goods: It includes demand from both domestic and foreign buyers for goods produced within the country (includes exports).
- Domestic demand for goods: It includes demand by residents of the country for goods, whether produced domestically or imported (includes imports).
Question 4. Would the central bank need to intervene in a managed floating system? Explain why? [3 Marks]
Answer:
Yes, the central bank may intervene in a managed floating exchange rate system. In this system:
- The exchange rate is largely determined by market forces of demand and supply.
- However, the central bank occasionally intervenes to stabilize the currency and prevent excessive fluctuations.
- The intervention may be done by buying or selling foreign currency in the open market.
Question 1. How is exchange rate determined under a flexible exchange rate regime?
Answer: In a flexible exchange rate system, the exchange rate is determined by the forces of demand and supply in the foreign exchange market. The equilibrium rate is established where demand for and supply of foreign exchange intersect.
The demand for foreign exchange arises from imports, foreign investments, and travel. The supply of foreign exchange comes from exports, remittances, and foreign investments in the domestic country.
At the point where demand and supply curves intersect, we get the equilibrium exchange rate and quantity.
Question 2. Differentiate between devaluation and depreciation.
| Basis | Devaluation | Depreciation |
|---|---|---|
| Meaning | Reduction in value of domestic currency by government under fixed exchange rate system | Fall in value of domestic currency due to market forces under flexible exchange rate system |
| Cause | Government action | Market demand and supply |
| System | Fixed exchange rate | Flexible exchange rate |
Question 3. Are the concepts of demand for domestic goods and domestic demand for goods the same?
Answer: No, they are different.
- Demand for domestic goods: Goods produced in the home country and demanded both domestically and internationally.
- Domestic demand for goods: Goods demanded within the country, including both domestic and imported goods.
Question 4. Would the central bank need to intervene in a managed floating system?
Answer: Yes. In a managed floating exchange rate system, central banks intervene occasionally to stabilize the currency and avoid excessive fluctuations, even though the rate is largely market-determined.
More Questions Solved
I. Very Short Answer Type Questions (1 Mark)
Question 1. What is foreign exchange?
Answer: It refers to currencies of other countries. For India, foreign exchange includes the US dollar, Euro, etc.
Question 2. What is meant by foreign exchange rate?
Answer: It is the rate at which one currency is exchanged for another.
Question 3. What is meant by foreign exchange market?
Answer: It is the market where foreign currencies are bought and sold.
Question 4. Define flexible exchange rate system.
Answer: It is a system where exchange rates are determined by demand and supply forces without government interference.
Question 5. The price of 1 US Dollar has fallen from ₹50 to ₹48. Has the Indian currency appreciated or depreciated?
Answer: The Indian currency has appreciated.
II. Multiple Choice Questions (1 Mark)
- Which function of foreign exchange market protects against the foreign exchange risk?
Answer: (b) Hedging function - Reduction in the value of domestic currency by the government is called:
Answer: (b) Devaluation - Reduction in the value of domestic currency through market forces is called:
Answer: (a) Depreciation - Increase in the value of domestic currency by the government is called:
Answer: (c) Revaluation - Increase in the value of domestic currency through market forces is called:
Answer: (d) Appreciation - What will be the effect on exports if foreign exchange rate increases?
Answer: (a) Increases - Foreign exchange is demanded by:
Answer: (d) All of them - The supply of foreign exchange comes from:
Answer: (d) All of them - Buyers and sellers of foreign exchange are:
Answer: (d) All of them - Which exchange rate measures the average relative strength of a currency without removing the effect of price changes?
Answer: (b) Nominal effective exchange rate - When one country manipulates exchange rate against the interest of others, it is known as:
Answer: (b) Dirty floating - When the price of foreign currency rises, national income is:
Answer: (a) Likely to rise - When the price of foreign currency falls, national income is likely:
Answer: (b) To fall
Short Answer Type Questions (3-4 Marks)
Question 1. State four sources of demand of foreign exchange.
Answer: The demand (or outflow) of foreign exchange comes from people who need it to make payments in foreign currencies. It is demanded by domestic residents for the following reasons:
- Imports of Goods and Services: Foreign exchange is required to pay for imported goods and services.
- Tourism: It is needed for expenses incurred during foreign travel.
- Unilateral Transfers Sent Abroad: Includes remittances like gifts sent to other countries.
- Purchase of Assets in Foreign Countries: Used for purchasing land, shares, or bonds abroad.
Question 2. What are the functions of a foreign exchange market?
Answer:
- Transfer Function: Facilitates transfer of purchasing power between countries.
- Credit Function: Provides credit in foreign exchange for international trade.
- Hedging Function: Protects against risks associated with exchange rate fluctuations.
Question 3. Why does demand for foreign exchange rise when its price falls?
Answer: The demand for foreign currency increases due to:
- Lower prices make imports cheaper, boosting demand for foreign goods and currency.
- Promotes tourism as traveling to that country becomes less expensive.
- Encourages speculative buying as people expect profits from currency value appreciation.
Question 4. When price of a foreign currency rises, its demand falls. Explain why?
Answer: The demand curve for foreign exchange is downward sloping due to an inverse relationship between exchange rate and demand. As foreign currency becomes costlier, imported goods become more expensive, leading to reduced imports and lower demand for foreign exchange.
Question 5. State four sources of supply of foreign exchange.
Answer: The supply (or inflow) of foreign exchange arises from:
- Exports of Goods and Services: Foreign buyers pay in foreign currency.
- Foreign Investment: Capital inflow from investors abroad.
- Remittances from Abroad: Includes gifts and transfers received.
- Speculation: Sale of foreign currency to benefit from exchange rate movements.
Question 6. What are the reasons of ‘rise in supply’ of foreign currency?
Answer: Supply of foreign currency increases when:
- Domestic goods become cheaper, leading to higher exports and foreign currency inflow.
- Foreign direct investment (FDI) increases as investors find higher returns.
- Speculators sell foreign currency expecting depreciation in its value.
Question 7. Why supply curve of foreign exchange is upward sloping?
Answer: The supply curve slopes upwards because a higher exchange rate means domestic goods become cheaper for foreigners, encouraging exports. Increased exports lead to greater supply of foreign exchange.
Question 8. Explain the effect of depreciation of domestic currency on exports.
Answer: Depreciation of domestic currency makes Indian goods cheaper for foreign buyers. This boosts exports as more goods can be bought using the same amount of foreign currency.
Question 9. Explain the effect of appreciation of domestic currency on imports.
Answer: Appreciation makes foreign goods cheaper for domestic buyers. It encourages more imports as people can now buy more goods for the same amount of money.
Question 10. What are the merits of fixed exchange rate system?
Answer:
- Stability: Reduces exchange rate fluctuations and helps in long-term planning.
- Encourages Trade: Predictability in exchange rates promotes international trade.
- Macro Policy Coordination: Facilitates economic policy planning between nations.
Question 11. What are merits of flexible exchange rate system?
Answer:
- No Reserve Requirement: Reduces need for large foreign exchange reserves.
- Capital Mobility: Facilitates flow of international capital.
- Promotes Venture Capital: Encourages trading in international currencies.
Question 12. Differentiate between fixed exchange rate and flexible exchange rate.
Answer:
| Basis | Fixed Exchange Rate | Flexible Exchange Rate |
|---|---|---|
| Determination | Fixed by government or central bank | Determined by market forces |
| Flexibility | Not flexible | Highly flexible |
Stability</td IV. True or FalseAre the following statements true or false? Give reasons. Question 1: An increase in demand for imported goods raises the supply for foreign exchange. Answer: False. Reason: When imports increase, people need more foreign currency to pay for those goods, which increases the demand for foreign exchange, not the supply. Question 2: Depreciation of Indian rupees will occur when Rs. 55 have to be paid to exchange one US $ instead of present rate of Rs. 50/$. Answer: True. Reason: Depreciation means more domestic currency is required to buy a unit of foreign currency. Since Rs. 55 is now needed instead of Rs. 50, the rupee has depreciated. Question 3: Appreciation of domestic currency leads to rise in imports. Answer: True. Reason: When domestic currency appreciates, foreign goods become cheaper in comparison, which leads to an increase in imports. Question 4: Revaluation and appreciation of currency are one and the same thing. Answer: False. Reason: Revaluation occurs under a fixed exchange rate system and is initiated by the government. Appreciation occurs under a flexible exchange rate system and is caused by market forces. Question 5: In spot market, sale and purchase of foreign currency is settled on a specified future date. Answer: False. Reason: In the spot market, transactions are settled immediately, not on a future date. V. Higher Order Thinking Skills (HOTS)Question 1: Define pegging operations. [1 Mark] Answer: Pegging operations are efforts by the central government or central bank to maintain a stable exchange rate of the domestic currency. Question 2: Define devaluation of currency. [1 Mark] Answer: Devaluation is a deliberate decrease in the value of a country’s currency relative to foreign currencies under a fixed exchange rate system. Question 3: Define revaluation of currency. Answer: Revaluation is a deliberate increase in the value of a country’s currency by the central government under a fixed exchange rate system. Question 4: Define Venture Capital. [1 Mark] Answer: Venture capital in the international money market refers to speculative investments made to earn profits from changes in foreign exchange rates. Fixed exchange rate discourages such investments. Question 5: What is managed floating rate? [CBSE 2010] [1 Mark] Answer: Managed floating rate is a hybrid system combining flexible exchange rates with occasional intervention by the central bank to stabilize the currency. Question 6: Name the market exchange rate system in which a central bank can actively intervene. [Sample Paper 2013] [1 Mark] Answer: Managed Floating Exchange Rate. Question 7: Differentiate between Currency Depreciation and Currency Appreciation. [3 Marks] Answer:
VI. Value-Based QuestionsQuestion 1: Do you think that a rise in BPO services is a good source of supply of foreign currency? [1 Mark] Answer: Yes. Export of services like BPO leads to inflow of foreign exchange, increasing the supply of foreign currency. Value: Critical Thinking Question 2: Suppose the present foreign exchange rate is 1$ = Rs. 50 and it rises to 1$ = Rs. 60. Should the central bank intervene? Answer: Yes. The central bank should intervene to protect the interests of importers and stabilize the economy. Value: Creative Thinking Question 3: What impact will fall on the expenditure of an American citizen who comes to India for medical treatment if the foreign exchange rate increases? Answer: The cost of treatment in India will reduce for him as his dollars will fetch more rupees. Value: Empathy Question 4: Why did India devalue its currency in 1991? Answer: To increase foreign exchange reserves and boost exports by making Indian goods more competitive. Value: Analytical Thinking VII. Application-Based QuestionsQuestion 1: How can Reserve Bank of India help in bringing down the foreign exchange rate which is very high? [AI 2013, Set 1] [1 Mark] Answer: RBI can sell foreign currency from its reserves, increasing supply in the market, thereby bringing down the foreign exchange rate. Question 2: What is the role of a Central Bank in the following exchange rate systems? [CBSE Sample Paper 2014] [3 Marks]
Question 3: ‘Devaluation and Depreciation of currency are one and the same thing’. Do you agree? How do they affect the exports of a country? [CBSE Sample Paper 2016] [3 Marks] Answer:
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