UPSC Prelims 2012 Q79: Indian Economy – External Sector & Balance Of Payments
Consider the following statements : The price of any currency in international market is
decided by the
1. World Bank
2. Demand for goods/services provided by the country concerned
3. Stability of the government of the concerned country
4. Economic potential of the country in question
Which of the statements given above are correct?
- (a) 1, 2, 3 and 4
- (b) 2 and 3 only
- (c) 3 and 4 only
- (d) 1 and 4 only
Answer: (b) 2 and 3 only
Explanation
What decides the price of a currency?
In the international market, a currency's price (its exchange rate) is set by demand and supply.
| Statement | Verdict | Reason |
|---|---|---|
| 1. World Bank | Incorrect | The World Bank gives development loans; it sets no exchange rates |
| 2. Demand for goods/services provided by the country concerned | Correct | Buyers of a country's exports must first buy its currency |
| 3. Stability of the government of the concerned country | Correct | Political stability attracts investors and capital |
| 4. Economic potential of the country in question | Not taken in the accepted key | It works more slowly, through expectations |
Working it out: Statement 1 is false, so options (a) and (d) fall.
Statement 2 is the most direct factor, so option (c), which leaves it out, also falls.
Exchange rate systems:
| System | Who sets the rate |
|---|---|
| Floating | The market |
| Fixed (pegged) | The government or central bank |
| Managed float (India) | The market, with RBI stepping in to curb sharp swings |
Answer: (b) 2 and 3 only.
Why each option is right or wrong
- (a) Incorrect. The World Bank does not decide the price of any currency.
- (b) CORRECT. Demand for goods/services and the stability of the government decide it.
- (c) Incorrect. It leaves out demand for goods/services, the most direct factor.
- (d) Incorrect. The World Bank plays no part in fixing currency prices.
Key point
Exchange rate: set by demand and supply of the currency (trade, capital flows, confidence, political stability); India follows a managed float. World Bank and IMF do not fix rates.
Remember
Currency price = demand and supply, not the World Bank.
Common mistakes
- Thinking the World Bank or the IMF fixes exchange rates.
- Ignoring political stability, which strongly moves capital flows.
- Forgetting that demand for a country's exports is demand for its currency.
Exam tip
Strike out the false statement first. Removing the World Bank leaves only two options to compare.
Sources
- NCERT Class XII — Introductory Macroeconomics, Ch 6 (Open Economy Macroeconomics)
- Reserve Bank of India — Exchange Rate Policy and Management