Q.OR (Question 12 alternative) Explain the effects of increase in supply of foreign currency on equilibrium exchange rate.
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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.
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.
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) …
Under a flexible exchange rate regime, the exchange rate is set by the demand for and supply of foreign currency — a rise in the supply of foreign currency pushes the exchange rate down, meaning the domestic currency appreciates. …
A rise in the supply of foreign currency (e.g. more dollars available in the forex market) shifts the supply curve rightward, lowering the equilibrium exchange rate — the domestic currency strengthens (appreciates) against the foreign currency.
In a flexible (floating) exchange rate system, the exchange rate — the price of one currency in terms of another — is determined purely by market demand for and supply of foreign currency, exactly like any other price is determined by demand and supply.
Effect of an increase in supply of foreign currency:
- Foreign currency (say, US dollars) becomes available in greater quantity in the domestic forex market — this could happen due to a rise in exports, more foreign investment inflows, more remittances, etc.
- At the original (old) equilibrium exchange rate, there is now an excess supply of foreign currency relative to demand.
- This excess supply pushes down the price of foreign currency in terms of the domestic currency — i.e., the equilibrium exchange rate (number of rupees per dollar) falls.
- A fall in the exchange rate (fewer rupees needed to buy one dollar) means the domestic currency has appreciated (become stronger), and correspondingly the foreign currency has depreciated. …
Showing the 12 most recent of 15 on this concept.
- CBSE 2026Set 58/2/11 markMCQQ.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.
›Reveal solutionSolution
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.
NoteThis 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). …
- CBSE 2025Set 58/4/11 markMCQQ.Under the __________ Exchange Rate System, the Central Bank can control the foreign exchange rate in a range bound manner. (Choose the correct option to fill in the blank) (A) Fixed (B) Flexible (C) Managed floating (D) Gold standard
›Reveal solutionSolution
Under a managed floating exchange rate system, the central bank intervenes selectively to keep the exchange rate within an acceptable range while allowing market forces to operate — the answer is (C).
The question asks us to identify the regime in which the central bank exercises partial control, steering the exchange rate within bounds rather than fixing it rigidly or leaving it entirely to the market.
Understanding the Exchange Rate Systems
An exchange rate system determines how a currency's value against foreign currencies is set. The four options represent different philosophies of control.
Fixed Exchange Rate: The central bank pegs the domestic currency to a foreign currency (or gold) at a declared rate and stands ready to buy or sell unlimited amounts of foreign exchange at that rate. The rate does not move; the bank sacrifices monetary autonomy to defend the peg. There is no "range" — only a single target.
Flexible (Floating) Exchange Rate: The rate is determined purely by demand and supply in the foreign exchange market. The central bank does not intervene. The rate can swing freely day to day; there is no attempt to control it within any band.
Gold Standard: A historical system in which currencies were convertible into fixed amounts of gold. Exchange rates between currencies were implicitly fixed by their gold parities. Again, no range-bound flexibility — rates were locked by the gold link. …
- CBSE 2025Set 58/5/11 markMCQQ.Market forces of demand and supply, actively interact under ________ exchange rate system to determine the foreign exchange rate. (Choose the correct option to fill in the blank) (A) fixed (B) flexible (C) managed floating (D) fixed floating
›Reveal solutionSolution
Under a flexible exchange rate system, market demand and supply determine the exchange rate without government intervention. The answer is (B) flexible.
The question asks which exchange rate regime allows market forces—demand and supply—to actively interact and determine the rate on their own. This is fundamentally about the degree of government intervention.
In a flexible (or floating) exchange rate system, the exchange rate is entirely determined by the interplay of demand and supply in the foreign exchange market. When demand for a currency rises (say, because foreigners want to buy more Indian goods), the currency appreciates; when supply increases (Indians buying more foreign goods, demanding foreign currency), it depreciates. The government and central bank do not intervene to fix or target any particular rate—the market clears at whatever price balances buyers and sellers. …
- CBSE 2025Set ANNUAL1 markMCQQ.Foreign exchange rate is determined by (A) Demand of foreign currency (B) Supply of foreign currency (C) Demand and supply in foreign exchange market (D) None of these
›Reveal solutionSolution
The foreign exchange rate is fixed by the interaction of demand and supply in the forex market, so the answer is (C).
In a free (flexible) exchange rate system, the exchange rate is a price — the price of one currency in terms of another — and like any price it is determined where the demand for foreign currency equals its supply. Demand for foreign exchange arises from imports, foreign travel and investment abroad; supply comes from exports and foreign inflows. The equilibrium exchange rate is the rate at which these two curves intersect in the foreign excha …
- CBSE 2025Set ANNUAL1 markMCQQ.Who determines the foreign exchange rate? (A) Government (B) Bargaining (C) World Bank (D) Demand and supply forces
›Reveal solutionSolution
The exchange rate is determined by the market forces of demand and supply, so the answer is (D).
Under a freely floating exchange rate system, the rate is not administratively fixed by the government, the World Bank, or by bargaining between parties. Instead it is decided by the interplay of demand for and supply of foreign currency in the foreign exchange market, just as any competitive price is set by demand and supply. (Under a managed float the cen …
- CBSE 2025Set ANNUAL1 markMCQQ.During Breton Woods system most countries had (A) Fixed Exchange Rate (B) Pegged Exchange Rate (C) Both (A) and (B) (D) None of these
›Reveal solutionSolution
Under the Bretton Woods system most countries followed a fixed exchange rate system, so the answer is (A).
The Bretton Woods Conference of 1944 established the IMF and a system of fixed exchange rates. Each member fixed its currency's par value in terms of the US dollar, and the US dollar was made convertible into gold at a fixed price. Exchange rates were held fixed within a narrow band (though they could be adjusted in cases of fundamental disequilibrium, an 'adjustable peg'). Beca …
- CBSE 2025Set ANNUAL1 markQ.Fill in the blank: The ________ has been setup to ensure stability in international transaction.
›Reveal solutionSolution
The blank is the International Monetary Fund (IMF), set up to maintain stability in international transactions.
In the RBSE/CBSE Class-12 open-economy chapter, the International Monetary Fund (IMF) was established (1944, Bretton Woods) to promote orderly exchange-rate arrangements, provide financial support to countries facing balance-of-payments difficulties, and thereby ensure stability in international monetary transactions. It he …
- CBSE 2024Set ANNUAL1 markMCQQ.Flexible exchange rate system is also known as(a) managed floating system(b) pegged exchange rate system(c) floating exchange rate system(d) None of the above
›Reveal solutionSolution
Flexible exchange rate = floating exchange rate: the rate is set purely by market demand and supply.
Under a flexible/floating system, if demand for foreign currency rises relative to supply, the domestic currency depreciates (and vice versa), all without the central bank buying or selling reserves to defend any particular rate. This is different from a fixed/pegged system (the central bank commits to and defends one rate) and from a managed floating system (the rate is largely market-determined but the central bank occasionally intervenes to …
- CBSE 2024Set ANNUAL1 markQ.What is fixed exchange rate?
›Reveal solutionSolution
Under a fixed exchange rate, the official authority pegs and defends the currency's value.
Historically this was done under systems like the gold standard or the Bretton Woods system, where a currency's value was tied to gold or to another major currency. To keep the rate at the announced level, the monetary authority stands ready to buy or sell its own currency (using foreign exchange reserves) whenever market pressure would otherwise push the rate away from the peg. This is the opposite of a flexible/flo …
- CBSE 2023Set ANNUAL1 markQ.What is meant by managed floating rate of exchange?
›Reveal solutionSolution
Managed floating combines a market-determined rate with occasional central bank intervention to smoothen fluctuations.
Exchange rate systems broadly fall between two extremes — a fixed exchange rate (officially pegged by the government/central bank) and a flexible/floating exchange rate (purely determined by market demand and supply, with no official intervention).
A managed floating rate of exchange is a middle path: the rate is allowed to be determined mainly by market forces of demand and supply for foreign exchange on a day-to-day basis, but the central bank (e.g. the RBI) retains the right to intervene in the foreign exchange market — buying or selling foreign currency from its reserves — whenever it judges that the rate is moving too sharply or becoming too volatile, in order to maintain orderly conditions, without …
- CBSE 2022Set ANNUAL1 markMCQQ.The exchange rate which is determined by the government is known as(a) flexible exchange rate(b) fixed exchange rate(c) floating exchange rate(d) None of the above
›Reveal solutionSolution
An exchange rate officially fixed/pegged by the government (or central bank) is called a fixed exchange rate.
Under a fixed exchange rate system, the government or central monetary authority declares an official par value of the domestic currency against a foreign currency (or gold) and commits to buying/selling foreign exchange at that rate, intervening in the market whenever necessary to defend it. This contrasts with a flexible/floating exchange rate (o …
- CBSE 2020Set 58/2/11 markQ.State whether the following statement is true or false : ‘‘Under a managed floating exchange rate system, the Government directly controls the exchange rate.’’
›Reveal solutionSolution
The statement is false. In a managed floating system, the exchange rate is primarily market-determined, with the central bank intervening indirectly (buying/selling reserves) to smooth volatility — not setting a fixed rate by direct government control.
Let’s first be clear on what a managed floating exchange rate system actually is, because the statement confuses it with a completely different regime.
In a pure floating (or freely floating) system, the exchange rate is determined entirely by market forces of demand and supply for foreign currency — no government or central bank action at all. In a fixed (or pegged) system, the government or central bank directly sets and maintains the exchange rate at a specific value, often by law or by standing ready to buy/sell foreign exchange at that price.
A managed floating system sits between these two extremes. Here, the exchange rate is largely market-determined, but the central bank occasionally intervenes in the foreign exchange market to influence the rate — not to fix it, but to prevent excessive short-term fluctuations or to guide it toward a desired range. This intervention is indirect: the central bank buys or sells foreign currency reserves (or adjusts interest rates) to affect demand or supply, thereby nudging the rate. It does not directly control or decree the rate. …
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