The market-determined exchange rate is Rs 50 per dollar. To encourage exports, the government fixes the rate at Rs 70 per dollar. Which of the following will follow?
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → An excess supply of dollars, which the RBI absorbs by buying dollars, so its foreign exchange keeps growing while it intervenes
At Rs 70 the dollar is kept dearer than the market rate of Rs 50. More dollars are offered than wanted, so there is an excess supply of dollars.
To hold Rs 70, the RBI buys these dollars for rupees. Its stock of foreign exchange keeps growing as long as it does so.
Excess demand and a black market would follow if the rate were fixed below the market rate.
NCERT (2026-27): “Fixed Exchange Rates … 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. Thus, the new exchange rate set by the Government is e1, where e1 > e. At this exchange rate, the supply of dollars exceeds the demand for dollars. The RBI intervenes to purchase the dollars for rupees in the foreign exchange market in order to absorb this excess supply which has been marked as AB in the figure. Thus, through intervention, the Government can maintain any exchange rate in the economy. But it will be accumulating more and more foreign exchange so long as this intervention goes on.” “… On the other hand if the goverment was to set an exchange rate at a level such as e2, there would be an excess demand for dollars in the foreign exchange market. To meet this excess demand for dollars, the government would have to withdraw dollars from its past holdings of dollars. If it fails to do so, a black market for dollars may come up. …” |