Previous Year Question
Given below are two statements, one is labelled as Assertion (A) and the other as Reason (R).
Assertion (A): The value of national currency determined by demand and supply of foreign currency is called flexible exchange rate.
Reason (R): Demand and supply of the foreign currency is being determined by the Central Bank.
Select the correct answer from the codes given below:
Both (A) and (R) are true and (R) is the correct explanation of (A).
(A) is false, but (R) is true.
Both (A) and (R) are true, but (R) is not the correct explanation of (A).
Both (A) and (R) are true, but (R) is not the correct explanation of (A).
Correct Answer: A
Detailed Solution
Assertion (A) is correct. A Flexible Exchange Rate is an exchange-rate arrangement in which the value of the domestic currency is determined primarily by the market forces of demand and supply in the foreign-exchange market.
For example, if demand for U.S. dollars increases in the Indian market while the supply of dollars remains unchanged, the price of the dollar in terms of rupees may rise, creating depreciation pressure on the rupee.
Conversely, an increase in the supply of foreign currency may create appreciation pressure on the domestic currency.
The RBI also states that the rupee exchange rate is determined primarily by market demand and supply.
Reason (R) is incorrect. The demand and supply of foreign currency are not themselves determined by the Central Bank.
Demand for foreign currency broadly arises from factors such as—
payments for imports,
foreign travel and education payments,
external debt payments, and
capital outflows.
The supply of foreign currency broadly comes from—
export receipts,
FDI and FPI inflows,
remittances, and
other foreign capital inflows.
Thus, forex demand and supply fundamentally arise from various market participants and cross-border transactions.
A Central Bank can certainly intervene in the foreign-exchange market. For example, the RBI may buy or sell dollars to curb excessive volatility. Such intervention can affect prevailing demand-supply conditions, but under a flexible/market-determined system, the Central Bank does not fundamentally determine the market's demand and supply.
In India's case, the exchange-rate regime is broadly a market-determined/managed float rather than a completely free float—market forces determine the exchange rate, while the RBI may intervene to smooth excessive volatility.