Read the passage carefully and answer the questions based on the passage:
THE FOREIGN EXCHANGE MARKET
The market in which national currencies are traded with one another is known as the foreign exchange market. The major participants in the foreign exchange market are commercial banks, foreign exchange brokers and other authorized dealers and monetary authorities. It is important to note that although participants themselves may have their own trading centers, the market itself is world-wide. There is close and continuous contact between the trading centers and the participants deal in more than one market.
Foreign currency flows into the home country for the following reasons: exports by a country lead to the purchase of its domestic goods and services by foreigners; foreigners send gifts or make transfers; and, the assets of a home country are bought by foreigners. A rise in the price of foreign exchange will reduce foreigners' costs while purchasing products from India and other things will remain constant. This increases India's exports and hence the supply of foreign exchange may increase.
Different countries have different methods of determining their currency's exchange rate. It can be determined through Flexible Exchange Rate, Fixed Exchange Rate or Managed Floating Exchange Rate. Floating exchange rate is determined by the market forces of demand and supply. Where fixed exchange rate is determined by the government at a particular level. In floating exchange rate increasing value of currency is known as appreciation and a decreasing value is known as devaluation where in fix exchange rate decreased value is known as devaluation. Managed floating exchange rate is combination of flexible and fixed exchange rate where at certain movement central intervene through market operation to manage currency exchange rate.
In an economy, to control a high balance of payment problem if government decided to reduce its currency value against globally accepted foreign currency, this process is known as:
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → Devaluation of Domestic Currency.
When a government itself decides to reduce the value of its currency, the step is called devaluation. It belongs to a fixed exchange rate system, where the government sets the rate.
Option (1) Appreciation of Domestic currency. — Incorrect. Under a flexible rate, appreciation means the domestic currency gains value. We then pay fewer rupees for one dollar.
Option (2) Depreciation of Domestic currency. — Incorrect. The currency loses value here too, but the market forces of demand and supply bring the fall about. Here the government takes the decision.
Option (3) Dirty Floating. — Incorrect. This is another name for managed floating. In this exchange rate system, central banks buy and sell foreign currencies to moderate the rate.
Option (4) Devaluation of Domestic Currency. — Correct. A government action raises the exchange rate, which makes the domestic currency cheaper. Here the government takes this step to deal with a balance of payments problem.
NCERT (2026-27): “Fixed Exchange Rates In this exchange rate system, the Government fixes the exchange rate at a particular level. … However, let us suppose that for some reason the Indian Government wants to encourage exports for which it needs to make rupee cheaper for foreigners it would do so by fixing a higher exchange rate, say Rs 70 per dollar from the current exchange rate of Rs 50 per dollar.… …In a fixed exchange rate system, when some government action increases the exchange rate (thereby, making domestic currency cheaper) is called Devaluation. On the other hand, a Revaluation is said to occur, when the Government decreases the exchange rate (thereby, making domestic currency costlier) in a fixed exchange rate system.” |