Country Z buys far more goods from abroad than it sells. Its imports of oil and machinery keep rising, while its exports grow slowly. Its citizens working abroad send money home to their families, but this covers only a small part of the gap. Foreign firms have set up new plants in Z, and Z’s companies have borrowed from banks abroad. Even so, the money coming into Z during the year is less than the money going out. Z follows a fixed exchange rate, and its central bank has stepped in to meet the shortfall.
Suppose Country Z let its exchange rate float freely instead. How would the market tend to close the gap between the money coming in and the money going out?
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → Z’s currency would depreciate, making its goods cheaper for foreigners.
More money going out means more demand for foreign exchange than supply. Under a floating rate, the exchange rate rises, so Z’s currency depreciates.
With a higher exchange rate, Z’s goods cost foreigners less, so exports rise. Imports become dearer and fall. This closes the gap without the central bank.
Devaluation is an official act under a fixed rate; under a free float the fall in value is depreciation.
NCERT (2026-27): “6.2.3 Merits and Demerits of Flexible and Fixed Exchange Rate Systems … The major advantage of flexible exchange rates is that movements in the exchange rate automatically take care of the surpluses and deficits in the BoP. …” “Supply of Foreign Exchange … A rise in price of foreign exchange will reduce the foreigner’s cost (in terms of USD) while purchasing products from India, other things remaining constant. This increases India’s exports and hence supply for foreign exchange may increase (whether it actually increases depends on a number of factors, particularly elasticity of demand for exports and imports.” |