Explain any two factors which affect exchange rate under flexible exchange rate system.

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Q. Explain any two factors which affect exchange rate under flexible exchange rate system.

Kerala DhseKerala DHSE Plus Two Commerce Board 2026Subjective· 4mImportance★★★★★

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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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In a flexible exchange rate system the rate is determined by the market demand and supply of foreign currency. Two important factors that shift these are the interest-rate differential and relative inflation rates; income changes and speculation also matter.

In a flexible (floating) exchange rate system, the exchange rate is not fixed by the government but is determined by the free interplay of the demand for and supply of foreign exchange. Any factor that changes this demand or supply changes the rate. This is a core idea in Kerala Plus Two (DHSE) economics open-economy macroeconomics, whose syllabus is aligned with the NCERT/CBSE curriculum.

Factor 1 — Difference in interest rates:

If the interest rate in the home country rises relative to abroad, foreign investors move funds into the home country to earn the higher return.
This capital inflow increases the demand for the domestic currency (and supply of foreign currency), so the domestic currency appreciates.
A fall in the domestic interest rate causes capital outflow and depreciation.

Factor 2 — Relative inflation (price levels):

If prices rise faster at home than abroad, domestic goods become costlier for foreigners while foreign goods become cheaper for residents.
Exports fall and imports rise, so demand for foreign currency rises and its supply falls. …

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Same / Similar Concept — real previous-year questions on the same or a closely similar concept, not this exact question.

Showing the 12 most recent of 13 on this concept.

CBSE 2026Set 58/1/11 markMCQ
$Q. Read the following statements carefully : Statement 1 : Depreciation of currency is an economic action undertaken by the government of a nation under the fixed exchange rate system. Statement 2 : Under the floating exchange Rate system, authorities actively intervene in the foreign exchange market by way of maintaining foreign exchange reserves. In the light of the given statements, choose the correct option from the following : (A) Statement 1 is true and statement 2 is false. (B) Statement 1 is false and statement 2 is true. (C) Both statements 1 and 2 are true. (D) Both statements 1 and 2 are false.$
›Reveal solutionSolution

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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CBSE 2026Set 58/2/11 markMCQ
$Q. Read the following statements - Assertion (A) and Reason (R). Choose the correct option from those given below : Assertion (A) : Increase in exchange rate implies that the price of foreign currency in terms of domestic currency has increased. Reason (R) : Balance of trade records the inflows and outflows of foreign exchange. Options : (A) Both Assertion (A) and Reason (R) are true and Reason (R) is the correct explanation of Assertion (A). (B) Both Assertion (A) and Reason (R) are true, but Reason (R) is not the correct explanation of Assertion (A). (C) Assertion (A) is true, but Reason (R) is false. (D) Assertion (A) is false, but Reason (R) is true.$
›Reveal solutionSolution
An increase in the exchange rate means foreign currency has become more expensive in terms of domestic currency. The Balance of Trade, however, only records visible goods, not all foreign exchange flows. Therefore, Assertion (A) is true, but Reason (R) is false.

Let's break down each statement to understand its meaning and truthfulness.

Understanding Assertion (A)

Assertion (A): Increase in exchange rate implies that the price of foreign currency in terms of domestic currency has increased.

The exchange rate is simply the price of one currency in terms of another. For instance, if the exchange rate is ₹80 per US dollar, it means that one US dollar costs 80 Indian rupees.

An "increase in the exchange rate" in this context typically refers to an increase in the number of units of domestic currency required to buy one unit of foreign currency.

Consider our example:

Initial exchange rate: ₹80 per US dollar

Increased exchange rate: ₹82 per US dollar

In this scenario, to buy one US dollar, you now need to pay ₹82 instead of ₹80. This means the foreign currency (US dollar) has become more expensive in terms of the domestic currency (Indian rupee). Conversely, the domestic currency has depreciated.

Therefore, Assertion (A) is True.

Understanding Reason (R)

Reason (R): Balance of trade records the inflows and outflows of foreign exchange.

The Balance of Trade (BOT) is a component of the Current Account of the Balance of Payments. It specifically records the difference between a country's exports and imports of visible goods (merchandise).

Exports of goods: Lead to an inflow of foreign exchange.

Imports of goods: Lead to an outflow of foreign exchange.

While the Balance of Trade does involve inflows and outflows of foreign exchange related to goods, it does not record all inflows and outflows of foreign exchange. The broader concept that records all economic transactions between residents of a country and the rest of the world, including visible trade, invisible trade (services), income, transfers, and capital transactions, is the Balance of Payments (BOP). …
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CBSE 2026Set 58/3/11 markMCQ
$Q. Under the fixed exchange rate system, if the government decreases the value of domestic currency with respect to a foreign currency, it is known as __________ of currency. (Choose the correct option to fill in the blank) Options : (A) Devaluation (B) Depreciation (C) Appreciation (D) Revaluation$
›Reveal solutionSolution
Under a fixed exchange rate system, a deliberate reduction in the value of a domestic currency by the government is termed devaluation.

To understand the correct term, we first need to distinguish between the two primary types of exchange rate systems: fixed and flexible (or floating). The mechanism by which a currency's value changes depends critically on which system is in place.

Under a fixed exchange rate system, the government or the central bank officially sets and maintains the exchange rate at a specific level against a foreign currency or a basket of currencies. To maintain this fixed rate, the central bank must intervene in the foreign exchange market by buying or selling foreign currency. If market forces push the domestic currency's value down, the central bank sells foreign currency to buy domestic currency, increasing demand for the domestic currency and supporting its value. Conversely, if market forces push the domestic currency's value up, the central bank buys foreign currency by selling domestic currency, increasing the supply of domestic currency and preventing its appreciation.

When the government or central bank deliberately decides to decrease the official value of its domestic currency relative to a foreign currency under this fixed system, this action is known as devaluation. This is a policy decision, often undertaken to make exports cheaper and imports more expensive, thereby improving the trade balance.

Note

Devaluation is a policy tool used by governments to adjust their currency's value in a fixed exchange rate regime.

In contrast, under a flexible exchange rate system, the value of a currency is determined purely by the forces of demand and supply in the foreign exchange market, without direct intervention from the government or central bank.

If the value of the domestic currency falls due to market forces (e.g., increased supply of domestic currency or decreased demand for it), it is called depreciation.

If the value of the domestic currency rises due to market forces (e.g., decreased supply of domestic currency or increased demand for it), it is called appreciation.

Similarly, if the government or central bank deliberately decides to increase the official value of its domestic currency relative to a foreign currency under a fixed exchange rate system, this action is known as revaluation. …
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CBSE 2026Set MARCH1 mark
$Q. What is appreciation of domestic currency?$
›Reveal solutionSolution

Appreciation of the domestic currency means a rise in its value against foreign currency, so fewer domestic units buy one unit of foreign currency.

Under a floating exchange rate system, the value of the domestic currency is determined by demand and supply in the foreign exchange market. Appreciation occurs when the domestic currency gains value, so that one unit of foreign currency (say a dollar) can now be bought with fewer units of domestic currency. For example, if the rate moves from Rs. 80 = 1 dollar to Rs. 75 = 1 dollar, the rupee has appreciated. Appreci …

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CBSE 2026Set ANNUAL1 markMCQ
$Q. When exchange rate in terms of domestic currency rises$
(a) Exports become cheaper
(b) Imports become cheaper
(c) Exports become costlier
(d) No effect on imports
›Reveal solutionSolution

When the exchange rate in terms of domestic currency rises (the domestic currency depreciates), exports become cheaper for foreigners, so the answer is (a).

The exchange rate 'in terms of domestic currency' means the amount of domestic currency needed to buy one unit of foreign currency (for example, rupees per dollar). When this rate rises, it takes more domestic currency to buy foreign currency, i.e. the domestic currency has depreciated (and the foreign currency has become dearer). As a result, foreigners now need less of their own currency …

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CBSE 2026Set ANNUAL1 mark
$Q. Fill in the blank: The process of making domestic currency cheaper by some government actions is called ________.$
›Reveal solutionSolution

Making the domestic currency cheaper by government action is devaluation.

Devaluation is the deliberate lowering of the official value (exchange rate) of the domestic currency by the government under a fixed exchange-rate system, making the domestic currency cheaper in terms of foreign currencies. It makes exports cheaper and imports dearer, helping to correct a balance-of-payments deficit. (Under a flexible system, …

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CBSE 2026Set ANNUAL1 markMCQ
$Q. Read the following Assertion (A) and Reason (R). Choose the correct alternative given below: Assertion (A): Devaluation of Indian rupee implies that more rupees are required to buy a dollar. Reason (R): Devaluation of domestic currency makes foreign goods more expensive.$
(a) Both Assertion (A) and Reason (R) are true, and Reason (R) is the correct explanation of Assertion (A)
(b) Both Assertion (A) and Reason (R) are true, but Reason (R) is not the correct explanation of Assertion (A)
(c) Assertion (A) is true but Reason (R) is false
(d) Assertion (A) is false but Reason (R) is true
›Reveal solutionSolution

Both statements are true in isolation, but Reason (R) explains an effect of devaluation, not why devaluation means more rupees are needed per dollar — that part is simply definitional.

Assertion (A): Devaluation is a deliberate, official reduction in the value of the domestic currency against foreign currencies under a fixed/pegged exchange rate system. If the rupee is devalued, by definition fewer dollars can now be bought for the same number of rupees — equivalently, more rupees are required to buy one dollar. This is true, and it is essentially the definition of devaluation.

Reason (R): When the rupee is devalued, imported goods (priced in foreign currency) now cost more in rupee terms, so foreign goods indeed become more expensive for Indian buyers. This is also true — it is a genuine consequence of devaluation (and is precisely why devaluation is used to discourage imports and encourage exports).

…

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CBSE 2025Set 58/6/11 markMCQ
$Q. Read the following statements - Assertion (A) and Reason (R) carefully. Choose the correct option from those given below : Assertion (A) : Other things remaining constant, devaluation of domestic currency may lead to rise in National Income of the nation. Reason (R) : Devaluation of domestic currency refers to reduction in the value of domestic currency by the government with respect to foreign currency under the fixed exchange rate system. Options : (A) Both Assertion (A) and Reason (R) are true and Reason (R) is the correct explanation of Assertion (A). (B) Both Assertion (A) and Reason (R) are true, but Reason (R) is not the correct explanation of Assertion (A). (C) Assertion (A) is true, but Reason (R) is false. (D) Assertion (A) is false, but Reason (R) is true.$
›Reveal solutionSolution

The assertion is true: devaluation can boost national income via net exports. The reason is also true: devaluation is a deliberate reduction in currency value under fixed exchange rates. But the reason merely defines devaluation — it does not explain why national income rises. So both are true, but (R) is not the correct explanation of (A). The correct option is (B).

Let’s unpack this step by step.

1. Understand the Assertion (A) first.

The claim is: Other things remaining constant, devaluation of domestic currency may lead to a rise in National Income.

Why would that happen? When a country devalues its currency, its exports become cheaper for foreign buyers, and imports become more expensive for domestic residents. This tends to increase export revenue and reduce import spending — so net exports (X – M) rise. Since National Income (Y) = C + I + G + (X – M), a rise in net exports directly increases aggregate demand and thus output and income. So the assertion is economically sound — it’s a standard argument from international trade theory.

Watch out

A common mistake is to think devaluation always raises income. It can, but only if the Marshall-Lerner condition holds (sum of price elasticities of exports and imports > 1). The assertion says “may lead to”, which is cautious and correct.

2. Now examine the Reason (R).

It says: Devaluation of domestic currency refers to reduction in the value of domestic currency by the government with respect to foreign currency under the fixed exchange rate system.

This is a textbook definition. Under a fixed exchange rate regime, the government or central bank sets the currency’s value. If it deliberately lowers that value, that’s devaluation. (Under floating rates, a similar fall is called depreciation, not devaluation.) So (R) is factually correct.

3. The key question: Does (R) explain (A)? …
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CBSE 2025Set ANNUAL1 markMCQ
$Q. Which of the following is an incorrect pair of country and its currency? (A) Japan - Yen (B) India - Rupee (C) Britain - Leera (D) United State of America - Dollar$
›Reveal solutionSolution
Britain's currency is the Pound Sterling, not the Lira, so the incorrect pair is (C).

In the RBSE/CBSE Class-12 open-economy chapter, international transactions involve exchanging national currencies. Checking each pair:

(A) Japan – Yen — correct.

(B) India – Rupee — correct. …
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CBSE 2025Set ANNUAL1 mark
$Q. Fill in the blank with the correct answer : If the value of US dollar in Indian rupee is increased, it means that the domestic currency has ________.$
›Reveal solutionSolution
More rupees required to buy one US dollar means the rupee has lost value relative to the dollar — this is called depreciation.

Under a flexible (market-determined) exchange rate system, the price of one currency in terms of another is set by demand and supply in the foreign exchange market.

If ₹1 bought $0.02 before, and now needs ₹85 to buy$ 1 (up from, say, ₹80), the rupee is worth less in dollar terms — this fall in the external value of the domestic currency, driven by market forces, is called depreciation. …
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CBSE 2024Set 58/3/11 markMCQ
$Q. Identify the correct pair of statements given in Column I with the related terms in Column II : Column I : 1. Remittances from abroad to the nation ; 2. Government's policy of decreasing the value of the nation's currency against foreign currencies ; 3. Difference between visible exports and visible imports of a nation ; 4. Government as sole authority of determining foreign exchange rates. Column II :$
(i) Accommodating Transaction ;
(ii) Devaluation ;
(iii) Balance of Payments ;
(iv) Flexible Exchange Rate System. Alternatives : (A) 1 →
(i) (B) 2 →
(ii) (C) 3 →
(iii) (D) 4 → (iv)
›Reveal solutionSolution
The correct pair identifies the government's policy of decreasing currency value as devaluation.

Understanding the dynamics of international trade and finance requires familiarity with several key concepts, particularly those related to a nation's interactions with the global economy. These include how a country pays for its imports, earns from its exports, and how the value of its currency is determined. The Balance of Payments (BoP) and exchange rate systems are central to this understanding.

Let us examine each statement and its potential match:

Remittances from abroad to the nation:

Remittances are transfers of money by foreign workers to their home country. These are essentially unilateral transfers, meaning they are one-way payments without any corresponding goods or services in return. In the context of a nation's Balance of Payments, remittances are recorded in the Current Account, specifically under "unrequited transfers" or "unilateral transfers." They represent an inflow of foreign exchange for the recipient nation.

(i) Accommodating Transaction: Accommodating transactions are those capital account transactions undertaken to cover the deficit or surplus in the autonomous transactions (which are undertaken for profit motive). Remittances are autonomous current account transactions, not accommodating capital transactions.

(iii) Balance of Payments: While remittances are part of the Balance of Payments, the term "Balance of Payments" itself refers to a systematic record of all economic transactions between the residents of a country and the rest of the world during a specific period. It is not a term specifically for remittances.

Government's policy of decreasing the value of the nation's currency against foreign currencies:

The value of a nation's currency can change relative to other currencies. When this change is a deliberate policy decision by the government or central bank in a fixed exchange rate system, it has a specific name.

(ii) Devaluation: Devaluation refers to the deliberate downward adjustment of a country's currency value relative to another currency, group of currencies, or standard. This is a policy action taken by the government or central bank, typically in a fixed exchange rate regime, to make exports cheaper and imports more expensive, aiming to improve the balance of trade. In contrast, depreciation is a fall in the currency's value due to market forces in a flexible exchange rate system. Given the statement specifies "Government's policy," devaluation is the precise term.

Important

Devaluation is a government policy action in a fixed exchange rate system, while depreciation is a market-driven fall in currency value in a flexible exchange rate system.

Difference between visible exports and visible imports of a nation:

International trade involves both visible (merchandise) and invisible (services) items.

Visible exports and imports refer to the trade in physical goods, such as machinery, textiles, or agricultural products.

The Balance of Trade (BoT) is specifically the difference between the value of a country's visible exports and its visible imports over a period. A surplus occurs if exports exceed imports, and a deficit if imports exceed exports. …
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CBSE 2024Set ANNUAL1 markMCQ
$Q. (viii) In fixed exchange rate system the exchange rate determinant is - A) Government B) Banks C) Multinational corporations D) Wealthy individuals$
›Reveal solutionSolution

In a fixed exchange rate system the exchange rate is pegged and managed by the government/central bank, so the answer is A.

Under a fixed (pegged) exchange rate system, the government or the central bank officially announces the exchange rate and then defends it by buying or selling foreign currency from its reserves. Any official change in this fixed rate is called devaluation (lowering) or revaluation (raising). Hence the exchange rate is determined by the government, not by bank …

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Q.Explain any two factors which affect exchange rate under flexible exchange rate system.

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