# NCERT Solutions for Class 12 Macro Economics Chapter 6: Open Economy Macroeconomics

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The NCERT Solutions for Class 12 Macro Economics cover all the questions pertaining to the subject in a very clear and lucid manner. Apart from being highly accurate, these solutions are also very easy to memorize. These solutions are written as per the latest CBSE syllabus and are helpful in clearing doubts. On this solution page, we have provided you with complete overview of the concepts and methods covered in the Chapter 6 of Macro Economics – Open Economy Macroeconomics.

## NCERT Solutions for Class 12 Macro Economics Chapter 6

### Open Economy Macroeconomics Solutions

#### Q2) What are official reserve transactions? Explain their importance in the balance of payments.

Answer) Official reserve transactions are transactions by a central bank that cause changes in its official reserve (ORT). These are usually purchases or sales of the company’s own currency on the exchange market in exchange for foreign currencies or other assets denominated in foreign currencies. The purchase of its own currency is considered as a credit (+) in the balance of payment, whereas a sale is a debit (-).

Importance of Official reserve transaction in balance of payments are:

1. Helps in adjusting deficit or surplus in balance of payments
2. Purchasing of own currency is regarded credit item in balance of payments where selling is regarded as a debit.

#### Q3) Distinguish between the nominal exchange rate and the real exchange rate. If you were to decide whether to buy domestic goods or foreign goods, which rate would be more relevant? Explain.

Answer) The nominal exchange rate is the price of a foreign currency expressed in local currency. The nominal exchange rate is the cost of acquiring one unit of foreign currency (say, a dollar) in terms of domestic currency (say, rupees). The exchange rate is expressed in terms of money, i.e. how many rupees per dollar. The nominal exchange rate, for example, is the price at which one American dollar can be purchased for 50 Indian rupees, or the price at which one dollar can be purchased for Rs.50. The real exchange rate is the price of imported goods relative to the price of domestic goods. Real exchange occurs when the cost of acquiring one unit of domestic currency (say, rupees) is expressed in terms of a foreign currency (say, dollar). For example, 1 rupee costs 2 cents (1 dollar=100 cents) in the example above. Visitors to America should be aware of how pricey American items are in comparison to those in their native country.

Real exchange rate = √(Pf/P)

Here,
P – Price level of domestic currency
e- Nominal exchange rate
Pf – Price level of the domestic currency

For example, if a watch costs \$40 in the United States and the nominal exchange rate is 50 , it should cost Rs 2,000 with a real exchange rate of
ePf = 50 × 40 = R = 2000

#### Q4) Suppose it takes 1.25 yen to buy a rupee, and the price level in Japan is 3 and the price level in India is 1.2. Calculate the real exchange rate between India and Japan (the price of Japanese goods in terms of Indian goods).

(Hint: First find out the nominal exchange rate as a price of yen in rupees).

Price level in a foreign country: (Japan) Pf = 3
The price level in home country: (India) P = 1.2
Real exchange rate = e(Pf/P)
Price of 1.25 yen = 1 rupee
Price of 1 yen = 1/1.25 = 100/125 = 4/5 Rupee
Therefore, e = 4/5 Rupee

So, real exchange rate = e(Pf/P) = 4/5 × 3/1.2 = 2

#### Q5) Explain the automatic mechanism by which BoP equilibrium was achieved under the gold standard.

Answer) In Gold standard system, gold is considered as a common unit to measure another nation’s currency or in other words value of a currency was defined in terms of gold. The exchange rates was fixed in upper and lower limits and it was allowed to fluctuate within those limits. Therefore exchange rates became stable under the gold standard and due to this reason all countries maintained their individual stock of gold which was used for currency exchange.

#### Q6) How is the exchange rate determined under a flexible exchange rate regime?

Answer) In a flexible exchange rate regime, rate of exchange is determined on the basis of demand and supply. The equilibrium is attained when demand and supply are equal to each other.

In this figure X axis represents demand for foreign currency while the Y axis represents exchange rates. Demand curve DD is sloping downward that shows the inverse relation between rate of exchange and demand for the foreign currency. The supply curve SS is upward sloping which shows the positive development of rate of exchange and supply of foreign currency. E is the point where equilibrium exchange rate is reached.

#### Q8) Would the central bank need to intervene in a managed floating system? Explain why.

Answer) A managed floating system is one in which market forces determine the foreign exchange rate. Through involvement in the international market, the central bank or government can influence the currency rate. It aids in the stabilization of exchange rates by facilitating the acquisition and sale of foreign money. It provides for exchange rate adjustments by established norms and regulations that are publicly reported in the foreign market.

#### Q9) Are the concepts of demand for domestic goods and domestic demand for goods the same?

Answer) No, both the concepts are not same as demand for domestic goods means demand for goods that are produced domestically in both domestic and international markets whereas domestic demand for goods means domestic demand of goods that are produced domestically or internationally. Demand for domestic goods is a broader concept includes domestic demand for goods.

#### Q10) What is the marginal propensity to import when M = 60 + 0.06Y? What is the relationship between the marginal propensity to import and the aggregate demand function?

Answer) The fraction of additional revenue spent on imports is known as the marginal propensity to import M = 60 + 0.06Y is a given value.

As a result, the marginal propensity to import (m) equals 0.06. It reflects induced imports, which are a portion of total imports that are a consequence of income.

Because the marginal inclination to import harms the aggregate demand function, aggregate demand falls as income rises. Because the extra money is spent on foreign goods rather than home items, this is the case.

#### Q11) Why is the open economy autonomous expenditure multiplier smaller than the closed economy one?

We can conclude that the multiplier in an open economy is less than the multiplier in a closed economy because the denominator in an open economy is bigger than the denominator in a closed economy by comparing equations (1) and (2) and the denominators of the two multipliers.

When compared to a closed economy, an increase in autonomous demand leads to a lesser growth in output.

#### Q12) Calculate the open economy multiplier with proportional taxes, T = tY, instead of lump-sum taxes as assumed in the text.

Answer) The equilibrium income in the case of proportional tax would be

Y = C + c(1−t)Y + I + G + X −M − mY
⇒ Y −c(1−t)Y + mY = C + I + G + X − M
⇒ Y[1 − c(1 − t) + m] = C + I + G + X − M
Y = (C + I + G + X − M) / [1 − C(1 − t) + m]

Autonomous expenditure (A) = C + I + G + X − M Therefore, open economy multiplier with proportional taxes.
ΔY/ΔA = 1/[1 − c(1 − t) + m]

#### Q13) Suppose C = 40 + 0.8Y D. T = 50, I = 60, G = 40, X = 90, M = 50 + 0.05Y

(a) Find equilibrium income
(b) Find the net export balance at equilibrium income
(c) What happens to equilibrium income and the net export balance when the government purchases increase from 40 to 50?

Answer a) C = 40 + 0.8YD
T = 50
I = 60
G = 40
X = 90
M = 50 + 0.05Y
Y = C + c(Y − T) + I + G + x − M − mY
Y = A/(1 − c + m)

Where,
A = C −cT + I + G + X − M
= (C − cT + I + G + X − M)/(1 − c + m)
= (40 − 0.8 × 50 + 60 + 40 + 90 − 50)/(1 − 0.8 + 0.05)
= (40 − 40 + 60 + 40 + 90 − 50)0.25
= 140/0.25
= (140/25) x 100
= 560.

Answer b) Net exports at equilibrium income:

NX = X − M − mY
= 90 − 50 − 0.05 × 560
= 40 − 28 = 12.

Answer c) When G increase from 40 to 50,

Equilibrium income (Y) = (C − cT + I + G + X − M)/(1 − c + m)
= (40 − 0.8 × 50 + 60 + 50 + 90 − 50)/(1 − 0.8 + 0.05)
= (40 − 40 + 60 + 50 + 90 − 50)0.25
= (150/25) x 100
= 600.

Net export balance at equilibrium income NX
X − (M + mY) = 90 − 50 − 0.05 × 600
= 40 – 30
= 10.

#### Q14) In the above example, if exports change to X = 100, find the change in equilibrium income and the net export balance

C = 40 + 0.8YD
T = 50
I = 60
G = 40
X = 100
M = 50 + 0.05Y

Equilibrium income (Y) = A/(1 − c + m)
= (C − cT + I + G + X − M)/(1−c+m)
= (40 − 0.8 × 50 + 40 + 60 + 100 − 50)/(1 − 0.8 + 0.05)
= (150/25) x 100
= 600.

Net export balance NX = X(M − mY)
= 100 − 50 − 0.05 × 600
= 50 – 30
= 20.

#### Q15) Explain why G − T = (Sp − I) − (X − M).

Answer) Savings and income are equal at equilibrium level in an economy while in an open economy savings and investments are different.

Y = C + I + G + X – M
NX = NX = X – M
Y = C + I + G + NX
Y – C – G = I + NX (eq.1)

Y – C – G can be regarded as national savings (S) or the net national income which is obtained after all consumption and government spending.

Therefore it can be written that:
Y – C – G = S
Or, S = I + NX
S = Private Savings (Sp) + Government Savings (Sg)

Now,
S = Sp + Sg
Sp + Sg = I + NX (as S = I + NX)
NX = Sp + Sg – I (eq.2)

We know that,

Sp = Y – C – T
Sg = T – G

Putting the values in eq.2 we get
NX = Y – C – T + T – G – I
NX = Y – C – G – I
G = Y – C – I – NX

Now subtracting T from both sides,
G – T = Y – C – I – NX – T
G – T = Y – C – T – I – NX
G – T = (Sp– I) – NX
Where, NX = X – M
G – T = (SP– I) – (X – M)

#### Q16) If inflation is higher in country A than in Country B, and the exchange rate between the two countries is fixed, what is likely to happen to the trade balance between the two countries?

Answer) Exchange rate plays an important role in the level of trade taking place in a country. In this question we see that country A is having a higher inflation than B. As exchange rate is fixed in this context it will be beneficial for the country A to import goods from country B and for B to export goods to country A. Therefore country A will be experiencing trade deficit as import is more than export and similarly country B will experience trade surplus as there is more export and comparatively less imports.

#### Q17) Should a current account deficit be a cause for alarm? Explain.

Answer) An excess of import of goods, services and transfers over total exports of goods, services and transfers is called as current account deficit. This situation makes a country debtor to all other nations of the world. But this generally cannot be considered an alarming situation because countries can be having deficits which is used for increasing productivity and exports in future.

#### Q18) Suppose C = 100 + 0.75Y D, I = 500, G = 750, taxes are 20 per cent of income, X = 150, M = 100 + 0.2Y. Calculate equilibrium income, the budget deficit or surplus and the trade deficit or surplus.

C=100+0.75YD
I=500
G=750
X=150
M=100+0.2Y

Equilibrium income (Y)=C+c(Y−T)+I+G+X−M−mY Or,
Y = I00 + 0.75(Y − 20/100Y) + 500 + 750 + 150 − 100 − 0.2Y
Or, Y = 1400 + (75/100) x (4Y/5) – 0.2Y
Or, Y = 1400 + 3/5Y – 0.2Y
Y = 1400 + 2Y/5
Y – (2Y/5) = 1400
3Y/5 = 1400
Y = 7000/3

Government expenditure =750
Government receipts(taxes) = (20/100) x (7000/3) = 1400/3 = 466.6

Since, government expenditure > government receipts, It shows the government is running on deficit budget.
NX=X−M−mY
= 150−100−0.2×7000/3
= 150−100−1400/3
= 150−100−466.66
= 150−566.66
= -416.66

It is a trade deficit, because the value of NX is negative.

#### Q19) Discuss some of the exchange rate arrangements that countries have entered into to bring about stability in their external accounts.

Answer) The following exchange rate arrangements helped bring stability in external accounts:

1. Crawling peg is a system of continuous and regular adjustments that allows a variation of 1% at any given time.
2. Under the system of wider bands adjustments are allowed in fixed exchange rates. A variation of 10% is applied between currencies of any two countries. A country can depreciate its currency to improve Balance of payments. It will lead to increase in demand of domestic goods as purchasing power of other currencies increase which results in more exports.
3. The third type is called as managed floating where the government has the authority to make changes in the exchange rate as per situation. The variation is not limited unlike the previous two measures.

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