Question

Choose the correct statements regarding the exchange rate system: \[ (A)\ \text{In a floating exchange rate system, the exchange rate is determined by market forces of demand and supply.} \] \[ (B)\ \text{In a fixed exchange rate system, making the domestic currency cheaper is called devaluation.} \] \[ (C)\ \text{An increase in the exchange rate implies that the price of foreign currency has increased, which is called depreciation.} \] \[ (D)\ \text{Exchange rates between two currencies adjust to reflect differences in price levels in the two countries.} \]

• A. (A), (B) and (C) only
• B. (A), (B) and (D) only
• C. (B), (C) and (D) only
• D. (A), (B), (C) and (D)

Hint:

Depreciation happens in a floating exchange rate system, while devaluation happens in a fixed exchange rate system when the government officially reduces the value of domestic currency.

Answer 1

The Correct Option is D

Concept:
Exchange rate means the price of one currency in terms of another currency. For example: \[ 1\$ = ₹80 \] This means one US dollar is equal to eighty Indian rupees. There are mainly two types of exchange rate systems: \[ \text{Fixed Exchange Rate System} \] and \[ \text{Floating Exchange Rate System} \] In a fixed exchange rate system, the government or central bank fixes the exchange rate. In a floating exchange rate system, the exchange rate is determined by the forces of demand and supply in the foreign exchange market.

Step 1: Checking statement (A).
Statement (A) says that in a floating exchange rate system, the exchange rate is determined by market forces of demand and supply. This statement is correct. In a floating exchange rate system, the exchange rate is not fixed by the government. It changes according to: \[ \text{Demand for foreign currency} \] and \[ \text{Supply of foreign currency} \] Therefore, statement (A) is correct.

Step 2: Checking statement (B).
Statement (B) says that in a fixed exchange rate system, making the domestic currency cheaper is called devaluation. This statement is also correct. In a fixed exchange rate system, if the government officially reduces the value of the domestic currency, it is called devaluation. For example, if the official exchange rate changes from: \[ 1\$ = ₹70 \] to \[ 1\$ = ₹80 \] then more rupees are required to buy one dollar. This means the rupee has been officially made cheaper. So, this is called devaluation. Therefore, statement (B) is correct.

Step 3: Checking statement (C).
Statement (C) says that an increase in the exchange rate implies that the price of foreign currency has increased, which is called depreciation. This statement is correct. For example, if the exchange rate changes from: \[ 1\$ = ₹80 \] to \[ 1\$ = ₹85 \] then the price of one dollar has increased in terms of rupees. Now more rupees are needed to buy one dollar. This means the domestic currency has become weaker. So, the domestic currency has depreciated. Therefore, statement (C) is correct.

Step 4: Checking statement (D).
Statement (D) says that exchange rates between two currencies adjust to reflect differences in price levels in the two countries. This is related to the concept of Purchasing Power Parity. According to this concept, exchange rates tend to adjust according to differences in price levels between countries. If prices are higher in one country compared to another, exchange rates adjust to reflect that difference. Therefore, statement (D) is also correct.

Step 5: Final conclusion.
All four statements are correct: \[ (A),\ (B),\ (C),\ (D) \] Hence, the correct answer is: \[ \boxed{\text{(D) (A), (B), (C) and (D)}} \]