Question

Read the following statements carefully:
Statement 1: Under the flexible exchange rate system, a deficit or surplus in the Balance of Payments is automatically corrected.
Statement 2: Under the flexible exchange rate system, there is always a possibility of over/under valuation of currency.
In the light of the above given statements, choose the correct option from the following:

• A. Statement 1 is true and Statement 2 is false.
• B. Statement 1 is false and Statement 2 is true.
• C. Both Statements 1 and 2 are true.
• D. Both Statements 1 and 2 are false.

Hint:

Flexible exchange rate system ensures automatic correction of external imbalances but may lead to frequent fluctuations in currency value.

Answer 1

The Correct Option is C

Concept: Flexible Exchange Rate System
In a flexible (or floating) exchange rate system, the value of a country's currency is determined by the forces of demand and supply in the foreign exchange market. There is minimal or no direct intervention by the government or central bank.
Step 1:Analyze Statement 1

• A deficit in the Balance of Payments (BoP) implies that demand for foreign currency exceeds its supply.
• As a result, the domestic currency depreciates in the foreign exchange market.
• Depreciation makes exports cheaper and imports more expensive.
• This leads to an increase in exports and a decrease in imports.
• Hence, the BoP deficit tends to get corrected automatically over time.

\[ \text{Statement 1 is true} \]
Step 2:Analyze Statement 2

• Under a flexible exchange rate system, exchange rates are determined by market forces.
• Due to constant changes in demand and supply, exchange rates may fluctuate frequently.
• Such fluctuations can sometimes result in overvaluation or undervaluation of the currency.
• This introduces uncertainty and volatility in international trade and investments.

\[ \text{Statement 2 is true} \]
Step 3:Conclusion
\[ \text{Both statements are correct} \]