Economics Class 12 Chapter 6 questions and answers: Open Economy Macroeconomics ncert solutions
| Textbook | NCERT |
| Class | Class 12 |
| Subject | Economics |
| Chapter | Chapter 6 |
| Chapter Name | Open Economy Macroeconomics class 12 ncert solutions |
| Category | Ncert Solutions |
| Medium | English |
Are you looking for Ncert Solutions for Class 12 Macro Economics Chapter 6 Open Economy Macroeconomics? Now you can download economics class 12 chapter 6 questions and answers pdf from here.
Question 1: Differentiate between balance of trade and current account balance.
Answer 1:
| Balance of Trade (BOT) | Current Account Balance (CAB) |
|---|---|
| Definition: The balance of trade refers to the difference between the value of a country’s exports and imports of goods over a specific period of time. | Definition: The overall balance of a country’s international transactions, including goods, services, income, and transfers. |
| Components: Only considers the export and import of goods. | Components: Includes trade in goods, services, income (such as dividends and interest), and current transfers (like remittances). |
| Narrower/Broader: A narrower concept, part of the current account. | Narrower/Broader: A broader concept that includes the balance of trade along with services, income, and transfers. |
| Impact: Directly impacts the trade surplus or deficit of goods. | Impact: Reflects the overall economic relationship with the rest of the world, not just goods. |
| Focus: Merchandise (tangible products). | Focus: Goods, services, and financial flows. |
Question 2: What are official reserve transactions? Explain their importance in the balance of payments.
Answer 2: Transactions that are carried out by the monetary authority of a country which makes changes in official reserves is known as official reserve transaction or ORT. These transactions include the purchase and sale of currency in the exchange market for other assets and foreign currencies. By selling foreign currencies in the exchange market during periods of deficit and purchasing them during surplus periods. The increase and decrease in the official reserve are called the balance of payments surplus and deficit, respectively.
The importance of official reserve transactions in balance of payments are the following:
- 1. Purchase of a country’s own currency is a credit item in the balance of payments; whereas, sale of the currency is a debit item.
- 2. It helps to adjust the deficit and surplus in balance of payments.
Question 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.
Answer 3: The nominal exchange rate is the rate at which one currency can be exchanged for another, without considering the relative prices of goods and services in the two countries. It reflects the direct value of one currency against another.
The real exchange rate adjusts the nominal exchange rate for differences in price levels between countries. It represents the relative value of goods and services between two economies and shows how much a basket of goods in one country costs compared to another, taking inflation into account.
Comparison Between Nominal and Real Exchange Rates:
| Aspect | Nominal Exchange Rate | Real Exchange Rate |
|---|---|---|
| Definition | The rate at which two currencies are exchanged in the market | The rate adjusted for inflation and price levels |
| Focus | Market rate of exchange without considering price levels | Reflects purchasing power after adjusting for price differences |
| Price Level Adjustments | No | Yes |
| Relevance | Useful for immediate currency conversion | Useful for comparing the cost of goods across countries |
| Influenced by Inflation | No | Yes |
If, I were to decide whether to buy domestic goods or foreign goods, then real exchange rate will be more relevant, because The real exchange rate shows the relative prices of goods and services between two countries, after adjusting for inflation. This means it helps you understand how much actual goods and services you can buy in one country versus another.
Question 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).
Answer 4: Given Data:
- Nominal exchange rate (yen per rupee): 1.25 yen = 1 rupee
Nominal Exchange Rate = \(\frac{1}{1.25} = 0.8 \, \text{rupees per yen}\) - Price level in Japan: 3
- Price level in India: 1.2
Formula for Real Exchange Rate (RER):
Real Exchange Rate (RER) = Nominal Exchange Rate × \(\left( \frac{\text{Price Level in Japan}}{\text{Price Level in India}} \right)\)
Calculation:
RER = \(0.8 \times \left( \frac{3}{1.2} \right) = 0.8 \times 2.5 = 2\)
The real exchange rate between India and Japan is 2, meaning Japanese goods are twice as expensive as Indian goods, after adjusting for price levels.
Question 5: Explain the automatic mechanism by which BoP equilibrium was achieved under the gold standard.
Answer 5: 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.
Question 6: How is the exchange rate determined under a flexible exchange rate regime?
Answer 6: In a flexible exchange rate regime (also known as a floating exchange rate regime), the value of a currency is determined by the market forces of demand and supply in the foreign exchange market. The exchange rate fluctuates freely, with no direct government or central bank intervention to stabilize or fix the rate. The equilibrium is attained when demand and supply are equal to each other.
In this figure, X-axis represents demand for foreign currency while the Y-axis represents exchange rates. Demand curve DD is sloping downward, which shows the inverse relationship between the rate of exchange and demand for foreign currency. The supply curve SS is upward sloping which shows the positive development of the rate of exchange and supply of foreign currency. E is the point where the equilibrium exchange rate is reached.
Question 7: Differentiate between devaluation and depreciation.
Answer 7: Devaluation and depreciation both refer to a decline in the value of a currency, but they occur under different circumstances and through different mechanisms.
| Devaluation | Depreciation |
|---|---|
| Definition: Devaluation is the deliberate reduction of the value of a country’s currency relative to another currency, group of currencies, or standard (such as gold). | Definition: Depreciation is the decline in the value of a country’s currency relative to another currency due to market forces, without direct government intervention. |
| Cause: It is a policy decision made by a government or central bank. Typically, this happens in countries with a fixed or semi-fixed exchange rate system. | Cause: It occurs in a floating exchange rate system where currency value is determined by supply and demand in the foreign exchange market. Factors influencing depreciation include inflation, interest rate differentials, political instability, or a country’s economic performance. |
| Mechanism: The government or central bank officially lowers the currency’s exchange rate. For example, if a country’s currency is pegged to the U.S. dollar, the authorities may decide to reduce the value of the currency relative to the dollar. | Mechanism: Depreciation happens naturally as a result of changes in economic conditions, such as when investors lose confidence in a country’s economy or there is a trade imbalance. |
| Purpose: Devaluation is often used to boost exports by making them cheaper in foreign markets, reduce trade deficits, or address economic problems such as a lack of foreign reserves. | Purpose: Unlike devaluation, depreciation is not a result of a deliberate policy action but rather reflects underlying economic forces. |
| Example: A government might devalue its currency from 10 units to 12 units per U.S. dollar, meaning it takes more of the domestic currency to buy one dollar. | Example: If the value of a currency drops from 10 units to 12 units per U.S. dollar due to market fluctuations, this is called depreciation. |
Question 8: Would the central bank need to intervene in a managed floating system? Explain why.
Answer 8: 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.
Question 9: Are the concepts of demand for domestic goods and domestic demand for goods the same?
Answer 9: No, both concepts are not the same as demand for domestic goods means demand for goods that are produced domestically in both domestic and international markets, whereas domestic demand for goods means domestic demand for goods that are produced domestically or internationally. Demand for domestic goods is a broader concept that includes domestic demand for goods.
Question 10: What is the marginal propensity to import when M = 60 + 0.06Y? What is the relationship between the marginal propensity to import and the aggregate demand function?
Answer 10: The fraction of additional revenue spent on imports is known as the marginal propensity to import M = 60 + 0.06Y is a given value.
As a result, the marginal propensity to import (m) equals 0.06. It reflects induced imports, which are a portion of total imports that are a consequence of income.
Because the marginal inclination to import harms the aggregate demand function, aggregate demand falls as income rises. Because the extra money is spent on foreign goods rather than home items, this is the case.
Question 11: Why is the open economy autonomous expenditure multiplier smaller than the closed economy one?
Answer 11: : 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
\(I=\frac{C+I+G}{1-c}\)
Let, (C + I + G) = A1
Or, \(\mathrm{Y}=\frac{A_{1}}{1-c} \cdots \cdots(i)\)
Or, \(\frac{\Delta Y}{\Delta A_{1}}=\frac{1}{1-c}\)
In the case of an open economy, the equilibrium level of income is given by
Y = C + CY + I + G + X − M − mY
Or Y − cY + mY = C + I + G − X − M
Or, Y(1 − c + m) = C + I + G + X − M
Y = ( C + I + G + X − M ) / 1 − c + m
(A2) = C + I + G + X − M
Or, Y = A2/1 − c + m
\(\frac{\Delta y}{\left(\Delta A_{2}\right)}=\frac{1}{(1-c+m)} \cdots \ldots(i i)\)
We can conclude that the multiplier in an open economy is less than the multiplier in a closed economy because the denominator in an open economy is bigger than the denominator in a closed economy by comparing equations (1) and (2) and the denominators of the two multipliers.
When compared to a closed economy, an increase in autonomous demand leads to a lesser growth in output.
Question 12: Calculate the open economy multiplier with proportional taxes, T = tY , instead of lump-sum taxes as assumed in the text.
Answer 12: 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 = \(\frac{C + I + G + X − M}{1-c(1-Y)+m}\)
Autonomous expenditure (A) = C + I + G + X − M
Therefore, open economy multiplier with proportional taxes
\(\frac{\Delta Y}{\left(\Delta A\right)}=\frac{1}{1-c(1-t)+m}\)
Question 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?
Answer 13: Let’s break down the problem step by step to solve for each part:
Given Equations and Values:
Consumption function: ( C = 40 + 0.8 YD )
- Where ( YD ) is disposable income and ( YD = Y – T ), with ( T = 50 ) (taxes).
- Therefore, ( C = 40 + 0.8(Y – 50) ).
- Investment: ( I = 60 )
- Government spending: ( G = 40 ) (later changes to 50 in part (c))
- Exports: ( X = 90 )
- Imports: ( M = 50 + 0.05Y )
- Net exports: ( NX = X – M )
(a) Find the Equilibrium Income:
At equilibrium, aggregate demand (AD) equals aggregate output (income), ( Y ). Aggregate demand is the sum of consumption (C), investment (I), government spending (G), and net exports (NX):
Y = C + I + G + NX
Step 1: Express consumption ( C )
We know ( C = 40 + 0.8(Y – 50) ), so we simplify:
C = 40 + 0.8Y – 40 = 0.8Y
Step 2: Express net exports ( NX )
Net exports ( NX = X – M ):
NX = 90 – (50 + 0.05Y) = 90 – 50 – 0.05Y = 40 – 0.05Y
Step 3: Set up the equilibrium equation
Now substitute ( C = 0.8Y ), ( I = 60 ), ( G = 40 ), and ( NX = 40 – 0.05Y ) into the equilibrium equation ( Y = C + I + G + NX ):
Y = 0.8Y + 60 + 40 + (40 – 0.05Y)
Step 4: Simplify and solve for ( Y )
Combine terms:
Y = 0.8Y + 60 + 40 + 40 – 0.05Y
Y = 0.8Y – 0.05Y + 140
Y = 0.75Y + 140
Y – 0.75Y = 140
0.25Y = 140
Y = \(\frac{140}{0.25} = 560\)
So, the equilibrium income ( Y = 560 ).
(b) Find the Net Export Balance at Equilibrium Income
Now that we know the equilibrium income is ( Y = 560 ), we can calculate the net export balance ( NX ).
Step 1: Calculate imports ( M ) at equilibrium
Using the import function ( M = 50 + 0.05Y ):
M = 50 + 0.05(560) = 50 + 28 = 78
Step 2: Calculate net exports ( NX )
Now, net exports ( NX = X – M = 90 – 78 ):
NX = 12
So, the net export balance at equilibrium income is ( 12 ).
(c) What happens when government purchases increase from 40 to 50?
Now, we need to find the new equilibrium income and net export balance after the government increases spending from ( G = 40 ) to ( G = 50 ).
Step 1: Set up the new equilibrium equation
With ( G = 50 ), the new equilibrium equation becomes:
Y = 0.8Y + 60 + 50 + (40 – 0.05Y)
Step 2: Simplify and solve for ( Y )
Combine terms:
Y = 0.8Y – 0.05Y + 150
Y = 0.75Y + 150
Y – 0.75Y = 150
0.25Y = 150
Y = \(\frac{150}{0.25} = 600\)
So, the new equilibrium income is ( Y = 600 ).
Step 3: Find the new net export balance at ( Y = 600 )
Step 3.1: Calculate imports ( M ) at the new equilibrium
Using the import function ( M = 50 + 0.05Y ):
M = 50 + 0.05(600) = 50 + 30 = 80
Step 3.2: Calculate net exports ( NX )
Now, net exports ( NX = X – M = 90 – 80 ):
NX = 10
So, the new net export balance is ( 10 ).
(a) The equilibrium income is 560.
(b) The net export balance at equilibrium income is 12.
(c) When government purchases increase to 50, the new equilibrium income is 600, and the new net export balance is 10.
Question 14: In the above example, if exports change to X = 100, find the change in equilibrium income and the net export balance.
Answer 14: Let’s now solve for the changes in equilibrium income and the net export balance given that exports increase from ( X = 90 ) to ( X = 100 ).
1. Updated Equations:
Given:
- ( C = 40 + 0.8YD ) (same as before)
- ( I = 60 ) (same as before)
- ( G = 40 ) (same as in the original problem)
- New exports: ( X = 100 )
- Imports: ( M = 50 + 0.05Y )
We will now find the new equilibrium income and net export balance with ( X = 100 ).
(a) Find the New Equilibrium Income
We follow the same procedure as before, but with the updated export value.
Step 1: Consumption function
The consumption function remains:
C = 40 + 0.8(Y – 50) = 0.8Y
Step 2: Net exports ( NX )
With the new exports ( X = 100 ) and imports ( M = 50 + 0.05Y ), net exports are:
NX = X – M = 100 – (50 + 0.05Y) = 100 – 50 – 0.05Y = 50 – 0.05Y
Step 3: Set up the equilibrium equation
The equilibrium condition is ( Y = C + I + G + NX ). Substituting the new values:
Y = 0.8Y + 60 + 40 + (50 – 0.05Y)
Step 4: Simplify and solve for ( Y )
Combine terms:
Y = 0.8Y – 0.05Y + 60 + 40 + 50
Y = 0.75Y + 150
Y – 0.75Y = 150
0.25Y = 150
Y = \(\frac{150}{0.25} = 600\)
So, the new equilibrium income is ( Y = 600 ).
(b) Find the Net Export Balance at the New Equilibrium Income
Now, we calculate the net export balance at the new equilibrium income ( Y = 600 ).
Step 1: Calculate imports ( M ) at ( Y = 600 )
Using the import function ( M = 50 + 0.05Y ):
M = 50 + 0.05(600) = 50 + 30 = 80
Step 2: Calculate net exports ( NX )
Now, with ( X = 100 ) and ( M = 80 ):
NX = X – M = 100 – 80 = 20
So, the new net export balance is ( 20 ).
Summary of Results:
- New equilibrium income: ( Y = 600 )
- New net export balance: ( NX = 20 )
Question 15: Suppose the exchange rate between the Rupee and the dollar was Rs. 30=1$ in 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.
Answer 15: 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.
Question 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?
Answer 16: Exchange rate plays an important role in the level of trade taking place in a country. In this question we see that country A is having a higher inflation than B. As exchange rate is fixed in this context it will be beneficial for the country A to import goods from country B and for B to export goods to country A. Therefore, country A will be experiencing trade deficit as import is more than export and similarly country B will experience trade surplus as there is more export and comparatively less imports.
Question 17: Should a current account deficit be a cause for alarm? Explain.
Answer 17: 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.
Question 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.
Answer 18: 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.
Question 19: Discuss some of the exchange rate arrangements that countries have entered ? into to bring about stability in their external accounts.
Answer 19: To combine the two extreme positions, `fixed’ and ‘flexible’, the following exchange rate arrangements are used by governments to bring stability in external accounts:
1. Wider Bands: A system that allows adjustment in fixed exchange rate is referred to as wider bands. It permits only 10% variation between the currencies of any two countries. For example, a country can improve its balance of payments (BoP) deficit by depreciating it’s currency, which leads to increase in demand for domestic goods due to increase in purchasing power of other currencies. This further leads to the increase in exports, hence improving the BoP.
2. Crawling Peg: Crawling peg system allows continuous and regular adjustments in the exchange rate. Only 1% of variation is allowed at a time.
3. Managed floating: Managed floating is a scheme under which government can intervene to vary the exchange rate when the situation demands so. There is no specific limit of variation as in crawling peg and wider bands.