UPSC Prelims 2021 Q8: Indian Economy – External Sector & Balance Of Payments

UPSC Prelims 2021, General Studies Paper I · Indian Economy

Consider the following statements: The effect of devaluation of a currency is that it necessarily 1. improves the competitiveness of the domestic exports in the foreign markets 2. increases the foreign value of domestic currency 3. improves the trade balance Which of the above statements is/are correct?

(a) 1 only
(b) 1 and 2
(c) 3 only
(d) 2 and 3

Answer: (a) 1 only

Explanation

Devaluation: What It Necessarily Does

Statement	Claim	Verdict	Detail
1	Devaluation improves competitiveness of exports	TRUE (necessarily)	Devaluation makes domestic goods cheaper in foreign currency. A US importer now pays fewer dollars per Indian product. This ALWAYS improves price-based export competitiveness.
2	Devaluation increases foreign value of domestic currency	FALSE	Devaluation LOWERS the value of domestic currency, not raises it. Rs 80 to a dollar becoming Rs 90 to a dollar means the rupee is WEAKER in foreign currency terms.
3	Devaluation improves trade balance	NOT NECESSARILY	The trade balance may WORSEN initially (J-curve effect) because import bills rise immediately in domestic currency while export volumes take time to respond. Improvement depends on the Marshall-Lerner condition: (Ex+Em > 1).

Only statement 1 is necessarily correct. Statement 3 depends on elasticities.

Answer: (a) 1 only.

Why each option is right or wrong

(a) CORRECT. Only statement 1 is necessarily true. Devaluation makes exports cheaper in foreign currency, boosting competitiveness. Statements 2 and 3 are wrong or conditional.
(b) Incorrect. Statement 2 is the OPPOSITE of what devaluation does.
(c) Incorrect. Trade balance improvement is NOT guaranteed - it depends on the Marshall-Lerner condition and faces the J-curve effect.
(d) Incorrect. Both statements 2 and 3 are wrong (or conditional).

Key point

Devaluation: rupee value FALLS in foreign currency. ALWAYS improves export price competitiveness (statement 1 TRUE). Trade balance improvement is CONDITIONAL (Marshall-Lerner condition, J-curve). Foreign value of currency FALLS, not rises.

Remember

Devaluation NECESSARILY improves export competitiveness (statement 1 correct) because domestic goods become cheaper in foreign currency. It LOWERS the foreign value of currency (statement 2 wrong). Trade balance improvement is not guaranteed - depends on Marshall-Lerner condition and faces the J-curve effect (statement 3 not necessarily true).

Common mistakes

Confusing devaluation with depreciation. Devaluation = deliberate official reduction in a FIXED exchange rate. Depreciation = market-driven fall in a FLOATING exchange rate. Both have similar effects.
Assuming trade balance always improves. The J-curve shows it can worsen first. Improvement requires the Marshall-Lerner condition: sum of export + import demand elasticities > 1.
Confusing 'increase foreign value' with 'increase domestic value'. Devaluation LOWERS the foreign value of domestic currency.

Exam tip

Devaluation vs Depreciation: Devaluation = policy decision (fixed exchange rate regimes). Depreciation = market movement (floating regimes). India devalued in 1966 and 1991. Post-1993, India moved to a managed float, so RBI now allows depreciation, not formal devaluation.

Sources

NCERT Class XII Macroeconomics - Chapter on Open Economy
IMF - Balance of Payments Manual (BPM6)

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