(a) The factors that affect foreign currency are:
1. Purchasing power parity: The different price levels of products determine the exchange in foreign currency. The price level influences the exchange rate.
2. Inflation: This leads to an increase in the price of commodity hence lesser the demand of the product compared to the cheaper product. This will push the country towards importing more, hence increasing the foreign currency demand.
3. Interest rate: Greater the interest rate higher is the rate of investment in the country. This increases the inflow of foreign currency in the market.
4. Investment: when foreign investment increases the inflow of foreign currency also increases.
(b) There are 4 components of Current Account:
1. Goods – trade in goods
2. Services (invisible) – trade in services e.g. tourism
3. Income – investment income
4. Current unilateral transfers – donations, gifts, grants, remittances.
Capital Account reflects the net changes in the ownership of national assets.
The Components of Capital Account
1. Foreign Direct Investment (FDI)
2. Foreign Portfolio Investment (FPI)
3. External Borrowings such as ECB
4. Reserve Account with the Central Bank
(i) Interest on a loan received from Nepal
Answer: Capital Account, as the loan received would be part of capital formation.
(ii) Import of mobile phones from China
Answer : Current Account, as here trade in goods are done.
(a) Autonomous and Accommodating transactions are two types of transaction done in the balance of payments.
Autonomous are those international economic transactions, that take place due to some economic motive such as maximizing profits. These items are also known as ‘above the line items'.
Autonomous transactions take place on both current and capital accounts of a BOP.
1. current account: the exports and imports of goods are autonomous transactions.
2. capital account: The receipts and repayments of long-term loans by private individuals are autonomous transactions.
Accommodating are the transactions that are undertaken to control the deficit or surplus in autonomous transactions. such as the transactions that are determined by the net consequences of autonomous transactions. These items are also known as ‘below the line items'.
(b) Devaluation of a currency occurs mostly in countries that have a fixed exchange rate regime.
a. Under the fixed-rate regime, the central bank or the government decides the value of the currency with respect to other foreign currencies.
b. So when the government or the central bank reduces the value of its currency, then it is known as the devaluation of the currency.
c. In this, the value of the domestic currency is reduced in terms of other foreign currencies.
d. This is done to increase the export of the country. When devaluation of the currency is done goods are available at cheaper rates and their demand increases.
Depreciation of a currency occurs in the countries that have a floating exchange rate regime.
a. Under floating exchange rate regimes, the value of a country's currency is determined by the market forces of demand and supply.
b. The exchange rate of the currency changes on a daily basis as per the demand and supply of that currency with respect to foreign currencies.
c. A currency depreciates when the supply of currency in the market increases while its demand falls.
d. Depreciation boosts import while decreases export.
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