Read the following statements carefully : Statement 1 : Depreciation of currency is an economic action underta

Question 68 of 77

Q. Read the following statements carefully : Statement 1 : Depreciation of currency is an economic action undertaken by the government of a nation under the fixed exchange rate system. Statement 2 : Under the floating exchange Rate system, authorities actively intervene in the foreign exchange market by way of maintaining foreign exchange reserves. In the light of the 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.

Arunachal CbseCBSE Class XII Board 2026MCQ· 1mImportance★★★★★

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Concept understanding — Currency Devaluation Depreciation

Let’s start with something you already know. Suppose you have ₹100 and you want to buy a toy that costs $2. If the exchange rate is ₹50 =$ 1, you can buy exactly one toy. Now imagine the rate changes to ₹100 = $1. Your ₹100 now buys only$ 1 — you can no longer afford the toy. The rupee has become weaker relative to the dollar. That’s the everyday feeling of a currency losing value.

What is Currency Depreciation?

Depreciation is the fall in the value of one currency in terms of another currency under a flexible (floating) exchange rate system. In this system, the market — supply and demand for currencies — decides the rate. If more people want to sell rupees and buy dollars, the rupee’s price falls. That’s depreciation.

Example: If the rate moves from ₹70/ $to ₹80/$ , the rupee has depreciated. Each dollar now costs more rupees.

Note

Depreciation happens automatically in a floating rate system. It is not a government decision — it’s a market outcome.

What is Currency Devaluation?

Devaluation is the official reduction in the value of a currency by the government or central bank under a fixed exchange rate system. Here, the government pegs the currency to another currency (say, the dollar) and then deliberately lowers that peg.

Example: If the government had fixed ₹70/ $and then announces a new fixed rate of ₹80/$ , that’s devaluation.

Watch out

Many students mix these up. Remember: Depreciation = market-driven fall (floating rate). Devaluation = government-driven fall (fixed rate). The effect is similar — your currency buys less foreign currency — but the cause is different.

Why Does It Matter? The Real Effects

1. Exports become cheaper, imports become costlier

When the rupee depreciates (or is devalued), Indian goods become cheaper for foreigners. A shirt that costs ₹500 earlier cost $10 at ₹50/$ . Now at ₹100/ $, it costs only$ 5. Foreign buyers buy more — exports rise.

But the reverse is painful. An imported laptop that cost $1000 earlier cost ₹50,000. Now it costs ₹1,00,000. Imports become expensive, hurting consumers and industries that rely on foreign raw materials.

2. Impact on the trade balance

If exports rise and imports fall, the trade deficit (exports minus imports) may shrink. But this is not guaranteed — if demand for imports is inelastic (people must buy them anyway), the import bill actually rises in rupee terms.

3. Inflation pressure

Since imported oil, machinery, and components cost more, production costs rise. Firms pass this on to consumers. This is called imported inflation.

4. Debt burden

If India has borrowed in dollars, a weaker rupee means we need more rupees to repay the same dollar debt. This increases the burden on the government and companies.

The Formula (Yes, there is one — but it’s simple)

The NCERT textbook does not give a separate formula for depreciation/devaluation itself. But the concept is tied to the exchange rate:

\text{Exchange Rate} = \frac{\text{Price of domestic currency}}{\text{Price of foreign currency}}

More commonly, we write it as:

\text{₹ per $} = \frac{\text{₹}}{\text{$}}

If this number rises, the domestic currency (₹) has depreciated or been devalued.

There is also the percentage change formula:

\text{Percentage depreciation} = \frac{\text{New rate} - \text{Old rate}}{\text{Old rate}} \times 100

Example: Rate goes from ₹70/ $to ₹80/$ .

\frac{80 - 70}{70} \times 100 = 14.3\%

The rupee has depreciated by 14.3% against the dollar.

Tip

Always check which currency is in the denominator. If the denominator currency strengthens, the numerator currency weakens. A rising ₹/$ rate means the rupee is falling.

A Diagram in Words

Draw a standard supply-and-demand graph for dollars. On the vertical axis, put “₹ per $” (the exchange rate). On the horizontal axis, put “Quantity of$ ”. …

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Statement 1 confuses depreciation (market-driven) with devaluation (government action under fixed rates); Statement 2 wrongly claims active intervention defines floating systems. Both statements are false.

The question tests whether you can distinguish between two exchange-rate regimes and the vocabulary that goes with each. The key is to understand what governments do versus what markets do in fixed and floating systems.

Fixed vs Floating Exchange Rates: Who Decides?

Under a fixed exchange rate system, the government (or central bank) pegs the domestic currency to another currency or a basket of currencies at a declared rate. The authorities must intervene in the foreign exchange market—buying or selling reserves—to defend that peg whenever market forces push the rate away from the official level. If the government chooses to lower the official value of the currency, that deliberate policy action is called devaluation. Conversely, raising the official value is revaluation. Both are government decisions.

Under a floating (or flexible) exchange rate system, the currency's value is determined by market forces of demand and supply in the foreign exchange market, with no commitment by the government to maintain any particular rate. The exchange rate fluctuates freely. When the currency loses value in the market, we call it depreciation; when it gains value, appreciation. These are market outcomes, not government decisions.

Note

A managed float (or "dirty float") sits between the two extremes: the rate mostly floats, but authorities occasionally intervene to smooth volatility or nudge the rate. India, for instance, operates a managed float—the RBI does not target a fixed rate but may buy or sell dollars to prevent excessive swings.

Evaluating Statement 1

Statement 1 says: "Depreciation of currency is an economic action undertaken by the government of a nation under the fixed exchange rate system."

This mixes up terminology. Under a fixed system, if the government lowers the currency's official value, the correct term is devaluation, not depreciation. Depreciation refers to a market-driven fall in value under a floating system, where the government does not set the rate. The statement incorrectly attributes a government action (which would be devaluation) to the term "depreciation" and places it in the fixed-rate context.

Statement 1 is false.

Evaluating Statement 2 …

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Fixed vs Floating Exchange Rates: Who Decides?

Evaluating Statement 1

Evaluating Statement 2 …

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