IGNOU : M.COM : IBO 1 : UNIT 4 : Q - 3. Write short notes on: i) Flexible exchange rate ii) Fixed exchange rate.

 

Ans. i) Flexible exchange rate - There is a close relationship between the balance of payment and the exchange rates of a currency. One should notice that a deficit is simply an excess demand for foreign currencies. Let us suppose that our imports are worth $5000 million and export earnings are $4500 which will not be enough to pay for our imports and there is a trade deficit of $500 million which is the excess of dollar demanded by our importers over dollar supplied by our exporters. The Central bank, which in our case is the Reserve Bank of India, has two options. One is to supply $500 million from foreign exchange reserves to meet the excess demand and this will show in the official account of the balance of payment. The second option is not to supply any dollars at all in which case the excess demand for dollar will exert pressure in the foreign exchange market on the exchange value of Indian Rupee. If the Rupee rate was Rs. 30 per $ before the deficit appeared, it may change to Rs. 35 per $. Figure 4.3 shows this with the rupee-dollar exchange rate being fixed as Rs. 30 at which the demand for dollar is $5000 million and the supply of dollar is $4500 million, leaving an unadjusted deficit of $500 million. At this stage you should understand why the demand curve is downward sloping and the supply curve upward sloping. We demand dollars to import goods and services from the United States. If dollar becomes cheaper (as the rate changes from Rs. 35 to Rs. 30 per dollar) the Indian importers find American goods cheaper in Rupee terms and therefore demand more imports from USA. A good whose price is $10 used to cost Rs. 350. But now it will cost' Rs. 300. We assume that the increase in Indian demand for U.S. goods does not affect the prices (measured in $) in the U.S. Since the importers would purchase more quantities but pay the same dollar prices, the demand for dollar increases. This is the reason why the demand downward sloping. The supply curve is upward sloping because more expensive the dollar is (as the rate changes from Rs. 30 to Rs. 35 per dollar) higher is the income in rupees from exports to the U.S. per unit of a good exported and greater is the quantity exported. Again, assuming the U.S prices are fixed, the amount of dollar supplied by the Indian exporters is more.

ii) Fixed exchange rate - As mentioned above, the adjustment of a deficit in the balance of payment under the fixed exchange rate system calls for official intervention in the markets. To maintain the exchange rates fixed RBI will have to supply the excess foreign currencies demanded in the market either from its reserves or from international borrowing. Such actions have monetary implications. The Indian importers purchase these additional foreign currencies they need for additional imports (which is the deficit) with Indian Rupee. Thus the Indian currency changes hand from the public to RBI through the banking system. The result is a fall in money supply in the process of adjustment of the deficit. A fall in money supply may lead to a fall in the price level which you may work out by using the familiar quantity theory of money. This improves our comparative advantage. Our exports become cheaper and sell more in the world market and the cheaper domestic import substitutes replace a part of our imports. This is how the deficit is adjusted. Remember that if all this do not happen, the deficit which was adjusted this year by sale of foreign currencies by RBI will reappear in the next year. Thus under the fixed exchange rate system a deficit in the balance of payment is adjusted by money supply changes and the consequent changes in the price level.