Read the following statements carefully : Statement 1 : Under the flexible exchange rate system, a deficit / s

Question 71 of 77

Q. Read the following statements carefully : Statement 1 : Under the flexible exchange rate system, a deficit / surplus in the Balance of Payments is automatically corrected. Statement 2 : Under the flexible exchange rate system, there is always a possibility of over/under valuation of currency. In the light of the above given statements, choose the correct option from the following : (A) Statement 1 is true and Statement 2 is false. (B) Statement 1 is false and Statement 2 is true. (C) Both Statements 1 and 2 are true. (D) Both Statements 1 and 2 are false.

Andaman Nicobar CbseCBSE Class XII Board 2026MCQ· 1mImportance★★★★★

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Concept understanding — Managed Floating System

You’ve probably seen this on the news: “The rupee fell today against the dollar.” Or maybe you’ve heard that the government sometimes “intervenes” to stop the rupee from falling too much. That tug-of-war — between letting the market decide the exchange rate and the central bank stepping in — is exactly what a managed floating system is about.

The everyday intuition

Imagine a fruit market where the price of mangoes is usually set by how many people want to buy and how many are available. That’s a free market. But suppose one day, a sudden rumor makes everyone panic and prices crash. The market regulator might step in and buy a bunch of mangoes to stop the price from falling too low. That’s intervention.

Now imagine the opposite: the regulator never touches the price at all, no matter what. That’s a pure floating system. A managed floating system sits in between — the price is mostly decided by demand and supply, but the central bank (in India, the RBI) occasionally steps in to smooth out extreme swings.

The precise meaning

In a managed floating exchange rate system (also called a dirty float), the exchange rate is primarily determined by market forces — the demand for and supply of foreign currency. But the central bank does not stay completely aloof. It buys or sells foreign currency to prevent the exchange rate from moving too sharply in either direction.

The NCERT Class-12 Macroeconomics textbook (Chapter 6, Open Economy Macroeconomics) puts it clearly: under this system, the central bank intervenes actively in the foreign exchange market without any fixed target for the exchange rate. The goal is not to defend a particular level, but to manage volatility.

Note

The word “managed” is key: the central bank manages the pace of change, not the level of the exchange rate. It’s like a parent letting a child ride a bicycle but holding the seat to prevent a fall — not steering, just steadying.

Why it matters

A pure floating system can be brutal. If a country’s exports suddenly fall, its currency can depreciate sharply, making imports expensive and fueling inflation. A pure fixed system, on the other hand, requires the central bank to constantly defend a target rate, which can drain its foreign exchange reserves.

The managed float gives the central bank the best of both worlds: it lets the market do most of the work (so the exchange rate reflects economic fundamentals), but it can step in to prevent disorderly movements — like a sudden panic or speculative attack.

Watch out

A common mistake is to think that “managed” means the central bank sets the rate. It does not. The rate is still market-determined; the central bank only leans against the wind — buying when the rupee is falling too fast, selling when it is rising too fast.

How it works in practice (a word-picture) …

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Under a flexible exchange rate system the BoP is automatically corrected through market-driven currency adjustments, so Statement 1 is true. But over-/under-valuation of a currency is a feature of a fixed exchange rate system, not a flexible one, so Statement 2 is false. The correct option is (A).

A flexible (floating) exchange rate system is one in which the value of the currency is determined by the market forces of demand and supply of foreign exchange, without the government or central bank fixing or defending a particular rate.

Statement 1 — automatic correction of the BoP (TRUE)

This is the celebrated advantage of flexible exchange rates. Suppose India runs a current-account deficit: it imports more than it exports, so demand for foreign currency (say dollars) exceeds its supply. In a flexible system this excess demand raises the price of the dollar in rupee terms — the rupee depreciates. A cheaper rupee makes Indian exports more competitive abroad and imports dearer at home, so over time exports rise, imports fall, and the deficit shrinks. A surplus triggers the reverse (appreciation). The price mechanism does the adjusting, so Statement 1 is true.

Note

This self-correcting property is precisely why flexible rates reduce the need for a country to hold large foreign-exchange reserves to defend a parity.

Statement 2 — over-/under-valuation of currency (FALSE)

Over-valuation and under-valuation describe a situation where a currency's official value differs from its equilibrium (market-clearing) value. This can happen only when someone sets the rate — i.e. under a fixed or managed exchange rate system, where the central bank pegs the currency above equilibrium (over-valued) or below it (under-valued). …

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Statement 1 — automatic correction of the BoP (TRUE)

Statement 2 — over-/under-valuation of currency (FALSE)

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