NCERT Solutions for Class 12 Economics Chapter 6: Open Economy Macroeconomics
These Class 12 Economics Chapter 6 solutions cover Open Economy Macroeconomics, the final chapter of Introductory Macroeconomics (NCERT, 2026–27 session). The chapter explains how an economy links with the rest of the world through the output, financial and labour markets, records those links in the Balance of Payments (BoP), and how the foreign exchange rate is determined under flexible, fixed and managed-floating systems. Below you will find every NCERT exercise question reproduced verbatim and solved — with all BoP and exchange-rate numericals worked out step by step and verified — plus key terms and formulas, extra practice, MCQs, Assertion–Reason questions and FAQs.
An open economy is one that interacts with the rest of the world through three channels — the output market (trade in goods and services), the financial market (trade in financial assets) and the labour market (movement of workers). Foreign trade affects aggregate demand: imports are a leakage from the circular flow while exports are an injection. All these transactions are recorded in the Balance of Payments, made up of the current account (goods, services and transfers), the capital account (assets), and errors and omissions; a current-account deficit must be financed by a capital-account surplus or by drawing down official reserves. The chapter then studies the foreign exchange market, the demand for and supply of foreign exchange, and how the exchange rate is fixed under flexible, fixed and managed-floating regimes, distinguishing depreciation/appreciation from devaluation/revaluation, and using the purchasing power parity (PPP) theory for long-run predictions. The appendix derives the open-economy multiplier, which is smaller than the closed-economy multiplier because the marginal propensity to import adds an extra leakage.
Key Concepts & Terms
Open economy: an economy that trades with other nations in goods and services and, most often, in financial assets too — through the output, financial and labour markets.
Balance of Payments (BoP): a record of all economic transactions in goods, services and assets between residents of a country and the rest of the world over a period (usually a year). Its parts are the current account, the capital account and errors and omissions.
Current account: the record of trade in goods (visible), services and income (invisibles) and transfer payments (gifts, remittances, grants). A surplus means the nation is a net lender; a deficit means it is a net borrower.
Balance of Trade (BOT): the difference between the value of exports and imports of goods only. Exports are a credit, imports a debit.
Net invisibles: the difference between exports and imports of invisibles — services (factor and non-factor income) and transfers.
Capital account: the record of all international transactions in assets (money, stocks, bonds, government debt). It includes FDI, FII, external borrowings and external assistance. Purchase of foreign assets is a debit; sale of domestic assets is a credit.
Autonomous vs accommodating transactions: autonomous (‘above the line’) transactions are made independently of the BoP position (e.g. to earn profit); accommodating (‘below the line’) transactions are official reserve transactions made to bridge the gap in the BoP.
Official reserve transactions: the buying/selling of foreign exchange by the central bank (RBI) to finance a BoP deficit or absorb a surplus. A fall (rise) in official reserves shows an overall BoP deficit (surplus).
Foreign exchange rate (forex rate): the price of one currency in terms of another — e.g. Rs 50 per dollar.
Nominal vs real exchange rate: the nominal rate is the price of one currency in terms of another; the real exchange rate (R = ePf/P) measures the relative price of foreign goods in terms of domestic goods and is the relevant rate for deciding whether to buy domestic or foreign goods.
Depreciation / appreciation: in a flexible regime, a market-driven fall (rise) in the value of the domestic currency — the price of foreign currency rises (falls).
Devaluation / revaluation: in a fixed regime, a deliberate government action that raises (lowers) the exchange rate, making the domestic currency cheaper (costlier).
Purchasing Power Parity (PPP): a long-run theory stating that exchange rates adjust so the same good costs the same in both countries; the currency of the country with higher inflation depreciates.
Marginal propensity to import (m): the fraction of an extra rupee of income spent on imports; M = M̄ + mY.
Important Formulas (Chapter 6)
BoP identity: Current account + Capital account ≡ 0 (when reserves do not change).
Trade balance / Net exports: NX = X − M (exports minus imports).
Real exchange rate: R = (e × Pf) / P, where e = nominal exchange rate (domestic currency per unit of foreign currency), Pf = foreign price level, P = domestic price level.
Open-economy equilibrium income: Y* = A / (1 − c + m), where A is total autonomous expenditure and c is the marginal propensity to consume.
Open-economy multiplier (lump-sum taxes): ΔY / ΔA = 1 / (1 − c + m).
PPP (fixed foreign prices): new exchange rate = old rate × (new domestic price level / old domestic price level).
NCERT Exercises — Full Solutions
All questions below are reproduced verbatim from the NCERT textbook’s end-of-chapter Exercises. Answers are original and exam-ready; every numerical is solved with complete working.
1. Differentiate between balance of trade and current account balance.
ANSWERBalance of trade (BOT) is the difference between the value of exports and imports of goods only (visible items) of a country in a given period. It is also called the trade balance.Current account balance is wider: it is the sum of the balance of trade plus the balance on invisibles (services, income and transfer payments). Thus, Current account balance = BOT + Net invisibles.In short, BOT records only visible (goods) trade, while the current account balance records both visible and invisible transactions. A country can have a deficit on its trade balance yet a surplus on its current account if its net invisibles (e.g. software exports, remittances) are large enough.
2. What are official reserve transactions? Explain their importance in the balance of payments.
ANSWEROfficial reserve transactions are the purchase and sale of foreign exchange (and other reserve assets) by the monetary authority — in India, the Reserve Bank of India — to settle the gap in the balance of payments. When there is a deficit, the RBI sells foreign exchange from its reserves (an ‘official reserve sale’); when there is a surplus, it buys foreign exchange, adding to reserves.Importance: (i) They are the accommodating (‘below the line’) item that finances any deficit or absorbs any surplus, so they ultimately balance the BoP. (ii) A decrease in official reserves signals an overall BoP deficit and an increase signals an overall surplus, so the change in reserves measures the true external imbalance. (iii) They are especially important under a fixed exchange rate regime, where the central bank must intervene to hold the rate at its chosen level. The monetary authorities are therefore the ultimate financiers of any BoP deficit and the recipients of any surplus.
3. 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.
ANSWERNominal exchange rate is simply the price of one currency in terms of another — for example, Rs 50 per dollar. It tells us how many units of domestic currency are needed to buy one unit of foreign currency, but says nothing about relative prices of goods.Real exchange rate measures the relative price of foreign goods in terms of domestic goods. It is R = (e × Pf) / P, where e is the nominal rate, Pf the foreign price level and P the domestic price level. It tells us how many units of domestic goods are needed to buy one unit of foreign goods.Which is more relevant for a buyer: the real exchange rate is more relevant. A consumer comparing domestic and foreign goods cares about how expensive foreign goods are relative to domestic goods, not just the currency price. The real exchange rate captures price levels in both countries, so it directly reflects the relative attractiveness of imported versus domestic goods (an index of competitiveness). If R is high, foreign goods are dearer and one should buy domestic goods, and vice versa.
4. 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).
ANSWER (numerical)Step 1 — Nominal exchange rate (rupees per yen): We are told 1.25 yen buy 1 rupee, i.e. 1 rupee = 1.25 yen. Therefore the price of one yen in rupees is e = 1 / 1.25 = 0.8 rupees per yen.Step 2 — Apply the real exchange rate formula: R = (e × Pf) / P, with foreign country = Japan, so Pf (Japan) = 3 and P (India) = 1.2.R = (0.8 × 3) / 1.2 = 2.4 / 1.2 = 2.Result: The real exchange rate is 2, meaning Japanese goods are twice as expensive as Indian goods (1 unit of Japanese goods costs 2 units of Indian goods).
5. Explain the automatic mechanism by which BoP equilibrium was achieved under the gold standard.
ANSWERUnder the gold standard, every currency was defined in terms of, and freely convertible into, a fixed quantity of gold, so exchange rates were effectively fixed. BoP equilibrium was restored automatically through the flow of gold and its effect on domestic prices (the ‘price–specie flow mechanism’).The mechanism: If a country ran a BoP deficit (imports exceeding exports), it had to pay the difference in gold, so gold flowed out. A fall in the gold stock reduced the money supply, which lowered domestic prices. Cheaper domestic goods then made exports more competitive and imports less attractive, so exports rose and imports fell, correcting the deficit.The opposite happened for a country with a surplus: gold flowed in, the money supply and prices rose, exports became dearer and imports cheaper, reducing the surplus. In this way gold movements automatically adjusted prices and trade flows until the BoP returned to balance, without deliberate government action.
6. How is the exchange rate determined under a flexible exchange rate regime?
ANSWERUnder a flexible (floating) exchange rate regime the rate is determined purely by the market forces of demand for and supply of foreign exchange, with no central bank intervention.Demand for foreign exchange comes from the need to import goods and services, to send gifts abroad and to buy foreign financial assets; the demand curve slopes downward because a higher price of foreign exchange (rupees per dollar) makes imports dearer and reduces the quantity demanded. Supply of foreign exchange comes from exports, transfers received and sale of domestic assets to foreigners; the supply curve slopes upward because a higher price of foreign exchange makes our goods cheaper to foreigners, raising exports and inflows.The equilibrium exchange rate is fixed at the point where the demand and supply curves intersect. If the demand for foreign exchange rises (say imports increase), the demand curve shifts right, the rupee depreciates and the exchange rate rises (e.g. from Rs 50 to Rs 70 per dollar); if supply rises, the rupee appreciates. The rate keeps adjusting automatically to clear the market.
7. Differentiate between devaluation and depreciation.
ANSWERDepreciation is a fall in the value of the domestic currency relative to a foreign currency that occurs automatically through market forces of demand and supply under a flexible exchange rate system. No government decision is involved.Devaluation is a fall in the value of the domestic currency that is brought about deliberately by the government under a fixed exchange rate system, by officially raising the exchange rate (making domestic currency cheaper).In both cases the domestic currency becomes cheaper (more rupees per dollar), but depreciation is market-driven under floating rates, while devaluation is a policy action under fixed rates. (Their opposites are appreciation, which is market-driven, and revaluation, which is government-driven.)
8. Would the central bank need to intervene in a managed floating system? Explain why.
ANSWERYes. A managed floating system (also called ‘dirty floating’) is a mixture of the flexible system (the ‘float’ part) and the fixed system (the ‘managed’ part). The exchange rate is broadly left to market forces, but the central bank does intervene whenever it feels necessary.Why it intervenes: the central bank buys and sells foreign currencies to moderate sharp or undesirable fluctuations in the exchange rate, to prevent excessive volatility, and to keep the rate within a range it considers appropriate for the economy. Because of this intervention, official reserve transactions are not equal to zero under managed floating (unlike a perfectly flexible system, where they are zero).
9. Are the concepts of demand for domestic goods and domestic demand for goods the same?
ANSWERNo, they are not the same in an open economy.Domestic demand for goods is the total demand by domestic residents (households, firms and government) for all goods, whether produced at home or abroad. It equals C + I + G.Demand for domestic goods is the demand for goods produced within the country, by both residents and foreigners. To obtain it, we add exports X (foreigners’ demand for our goods) to domestic demand and subtract imports M (the part of domestic demand that falls on foreign goods): Demand for domestic goods = C + I + G + X − M.In a closed economy (no exports or imports) the two concepts coincide, but in an open economy they differ by net exports (X − M).
10. 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?
ANSWERMarginal propensity to import (m): In the import function M = M̄ + mY, the coefficient of Y is the marginal propensity to import. Here M = 60 + 0.06Y, so m = 0.06. It means that out of every additional rupee of income, 6 paise (0.06 rupee) is spent on imports.Relationship with the aggregate demand function: Imports are a leakage from the circular flow, so they are subtracted from aggregate demand. A higher m means that a larger part of any rise in income leaks out into imports, leaving a smaller demand for domestic goods. This makes the aggregate demand (for domestic output) function flatter — its slope falls from c to (c − m) — and it reduces the value of the multiplier. Thus m and the slope of the AD function for domestic goods are inversely related.
11. Why is the open economy autonomous expenditure multiplier smaller than the closed economy one?
ANSWERThe closed-economy multiplier is 1 / (1 − c), while the open-economy multiplier is 1 / (1 − c + m). Since the marginal propensity to import m is positive, the denominator is larger in the open economy, so the multiplier is smaller.Reason: In the multiplier process, a rise in autonomous expenditure raises income, which induces further consumption. In an open economy, a part of this induced consumption is spent on foreign (imported) goods, not domestic goods. Imports are an additional leakage from the circular flow of domestic income at each round of the multiplier. Because some demand ‘escapes’ abroad, the induced effect on domestic income at each round is smaller, so the cumulative expansion of income is smaller. Hence the open-economy multiplier is smaller than the closed-economy multiplier.
12. Calculate the open economy multiplier with proportional taxes, T = tY, instead of lump-sum taxes as assumed in the text.
ANSWER (derivation)Step 1 — Write equilibrium with proportional taxes: Disposable income YD = Y − T = Y − tY = (1 − t)Y. The equilibrium condition isY = C̄ + c(1 − t)Y + I + G + X − M̄ − mY.Step 2 — Collect autonomous terms as A (A = C̄ + I + G + X − M̄):Y = A + c(1 − t)Y − mY.Step 3 — Bring income terms to one side: Y − c(1 − t)Y + mY = A, i.e. Y[1 − c(1 − t) + m] = A.Step 4 — Solve for the multiplier:Open-economy multiplier = ΔY / ΔA = 1 / [1 − c(1 − t) + m].Compared with the lump-sum-tax multiplier 1 / (1 − c + m), the proportional-tax term −c(1 − t) makes the denominator larger (since taxes now also rise with income, adding a further leakage), so this multiplier is even smaller.
13. Suppose C = 40 + 0.8YD, 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 and 50?
ANSWER (numerical)(a) Equilibrium income. At equilibrium, Y = C + I + G + X − M, with YD = Y − T.Y = 40 + 0.8(Y − 50) + 60 + 40 + 90 − (50 + 0.05Y)Y = 40 + 0.8Y − 40 + 60 + 40 + 90 − 50 − 0.05YY = 140 + 0.75Y ⇒ Y − 0.75Y = 140 ⇒ 0.25Y = 140 ⇒ Y = 560.(b) Net export balance at Y = 560. NX = X − M = 90 − (50 + 0.05 × 560) = 90 − (50 + 28) = 90 − 78 = +12 (a net-export surplus of 12).(c) Government purchases rise from 40 to 50 (ΔG = 10). The open-economy multiplier = 1 / (1 − c + m) = 1 / (1 − 0.8 + 0.05) = 1 / 0.25 = 4.ΔY = multiplier × ΔG = 4 × 10 = 40, so new equilibrium income = 560 + 40 = 600.New net exports: NX = 90 − (50 + 0.05 × 600) = 90 − (50 + 30) = 90 − 80 = +10. So net exports fall by 2 (from 12 to 10), because higher income raises imports.
14. In the above example, if exports change to X = 100, find the change in equilibrium income and the net export balance.
ANSWER (numerical)Using the original figures (G = 40), exports rise from 90 to 100, so ΔX = 10. The multiplier is again 1 / (1 − 0.8 + 0.05) = 1 / 0.25 = 4.Change in equilibrium income: ΔY = 4 × ΔX = 4 × 10 = +40. New equilibrium income = 560 + 40 = 600.New net export balance: NX = X − M = 100 − (50 + 0.05 × 600) = 100 − (50 + 30) = 100 − 80 = +20.The net export balance was +12 before, so it rises by 8. Although income (and hence imports) rose by 40 × 0.05 = 2, the rise in exports of 10 more than offsets it, so net exports improve from 12 to 20.
15. Suppose the exchange rate between the Rupee and the dollar was Rs. 30=1$ in the year 2010. Suppose the prices have doubled in India over 20 years while they have remained fixed in USA. What, according to the purchasing power parity theory will be the exchange rate between dollar and rupee in the year 2030.
ANSWER (numerical)According to the purchasing power parity (PPP) theory, the exchange rate adjusts to reflect the relative price levels of the two countries. New rate = old rate × (Indian price index now / Indian price index then) × (US price index then / US price index now).Indian prices have doubled (ratio = 2); US prices are unchanged (ratio = 1).New exchange rate = 30 × 2 × 1 = Rs 60 = 1$.Result: Because inflation in India is higher than in the USA, the rupee depreciates; by 2030 the exchange rate is Rs 60 per dollar.
16. 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?
ANSWERIf the exchange rate is fixed, it cannot adjust to offset the inflation difference. With higher inflation in country A, the prices of A’s goods rise relative to B’s goods, but the currency price stays the same.As a result, A’s goods become relatively more expensive and B’s goods relatively cheaper. So country A’s exports fall (foreign buyers find them dear) and its imports rise (cheaper goods from B are attractive). The trade balance of country A worsens (moves towards/into deficit), while country B’s trade balance improves (moves towards/into surplus). The higher-inflation country loses competitiveness because the fixed rate prevents an automatic correction.
17. Should a current account deficit be a cause for alarm? Explain.
ANSWERNot necessarily. A current account deficit means a country is spending more than it earns from the rest of the world, so it is a net borrower and must finance the gap by a capital account surplus (net capital inflow) or by drawing on reserves.When it is not alarming: if the borrowed foreign funds are used for productive investment that raises the economy’s future output and export capacity, the deficit is healthy — the country can repay later from higher income. A developing economy importing capital goods to build industries is a good example.When it is alarming: if the deficit arises because borrowing finances current consumption rather than investment, or if it is large and persistent, debt and interest obligations pile up, foreign-exchange reserves may run down, and the country can face a debt or balance-of-payments crisis. Thus a current account deficit must be judged by its size, persistence and the use to which the borrowed resources are put, not treated as automatically bad.
18. Suppose C = 100 + 0.75YD, 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.
ANSWER (numerical)Step 1 — Set up equilibrium. Taxes are proportional: T = 0.2Y, so YD = Y − 0.2Y = 0.8Y. Equilibrium: Y = C + I + G + X − M.Y = 100 + 0.75(0.8Y) + 500 + 750 + 150 − (100 + 0.2Y)Y = 100 + 0.6Y + 500 + 750 + 150 − 100 − 0.2YY = 1400 + 0.4Y ⇒ Y − 0.4Y = 1400 ⇒ 0.6Y = 1400 ⇒ Y = 2333.33 (i.e. 7000/3).Step 2 — Budget deficit/surplus. Government revenue T = 0.2 × 2333.33 = 466.67; government spending G = 750.Budget balance = T − G = 466.67 − 750 = −283.33, i.e. a budget deficit of about 283.33.Step 3 — Trade deficit/surplus. Imports M = 100 + 0.2 × 2333.33 = 100 + 466.67 = 566.67; exports X = 150.Trade balance = X − M = 150 − 566.67 = −416.67, i.e. a trade deficit of about 416.67.
19. Discuss some of the exchange rate arrangements that countries have entered into to bring about stability in their external accounts.
ANSWERCountries have adopted several exchange-rate arrangements to stabilise their external accounts:(i) Gold standard: currencies were defined in, and convertible into, fixed amounts of gold, so exchange rates were fixed and the BoP adjusted automatically through gold flows.(ii) Bretton Woods (adjustable peg) system: after 1944, the US dollar was pegged to gold and other currencies were pegged to the dollar at fixed but adjustable rates, with the IMF helping to finance temporary deficits; it broke down in the early 1970s.(iii) Fixed exchange rate system: the government fixes the rate and the central bank buys or sells foreign exchange to maintain it, giving stability but requiring large reserves and exposing the currency to speculative attacks.(iv) Flexible (floating) exchange rate system: the rate is left to demand and supply, so the BoP corrects automatically and the country gains monetary-policy independence, but rates can be volatile.(v) Managed floating (dirty float): the most common modern arrangement — basically a float, but the central bank intervenes to smooth excessive fluctuations. Some countries also use currency boards or adopt a common currency to gain stability.
Extra Practice Questions
Short Answer Type Questions
Q1. State any two reasons why people demand foreign exchange.
ANSWERPeople demand foreign exchange (i) to import goods and services from other countries, and (ii) to purchase foreign financial assets (and to send gifts/transfers abroad). A rise in the price of foreign exchange raises the rupee cost of imports and reduces this demand.
Q2. What is meant by ‘net invisibles’ in the balance of payments?
ANSWERNet invisibles is the difference between the value of exports and imports of invisible items — services (factor and non-factor income such as shipping, banking, software and tourism) and transfers. It is a part of the current account along with the balance of trade.
Q3. Define the open-economy multiplier.
ANSWERThe open-economy autonomous expenditure multiplier is the ratio of the change in equilibrium income to the change in autonomous expenditure: ΔY/ΔA = 1/(1 − c + m). Because the marginal propensity to import m > 0, it is smaller than the closed-economy multiplier 1/(1 − c).
Q4. Distinguish between autonomous and accommodating transactions in the BoP.
ANSWERAutonomous transactions (‘above the line’) are undertaken for their own sake (e.g. to earn profit), independently of the BoP position. Accommodating transactions (‘below the line’) are official reserve transactions made specifically to bridge the gap in the BoP. The BoP is in surplus or deficit depending on whether autonomous receipts exceed or fall short of autonomous payments.
Q5. Why are imports treated as a leakage and exports as an injection in the circular flow?
ANSWERWhen Indians buy foreign goods, the spending leaves the domestic circular flow and becomes income of a foreign country, reducing domestic aggregate demand — hence imports are a leakage. When foreigners buy our exports, money enters the domestic circular flow and raises aggregate demand for domestically produced goods — hence exports are an injection.
Long Answer Type Questions
Q1. Explain the structure of the Balance of Payments account, distinguishing the current and capital accounts.
ANSWERThe Balance of Payments records all economic transactions between residents of a country and the rest of the world over a year, and has three parts. The current account records trade in goods (visible exports and imports, giving the balance of trade), trade in services and income (factor and non-factor), and transfer payments such as gifts, remittances and grants (giving net invisibles). A current-account surplus makes the nation a net lender, a deficit a net borrower. The capital account records all international transactions in assets — FDI, FII (portfolio), external borrowings and external assistance; purchase of foreign assets is a debit and sale of domestic assets is a credit. A surplus arises when capital inflows exceed outflows. The third element, errors and omissions, allows for the fact that not all transactions can be recorded accurately. By the identity, any current-account deficit must be financed by a capital-account surplus or by a fall in official reserves, so the overall BoP balances.
Q2. Explain how the exchange rate is determined under fixed, flexible and managed-floating systems, and compare their merits.
ANSWERUnder a flexible (floating) system, the exchange rate is set freely by the demand for and supply of foreign exchange, and the central bank does not intervene; movements in the rate automatically correct BoP surpluses and deficits and the country keeps monetary-policy independence, though rates can be volatile. Under a fixed system, the government fixes the rate (say above the market rate to encourage exports) and the central bank intervenes — buying excess supply of dollars or selling dollars to meet excess demand — to hold it there; this gives stability and certainty for trade but needs large reserves and exposes the currency to speculative attacks if reserves seem inadequate (as before the collapse of the Bretton Woods system). Under a managed floating (dirty float) system, the rate is broadly market-determined but the central bank intervenes to moderate excessive fluctuations, so official reserve transactions are not zero. Managed floating tries to combine the flexibility and automatic adjustment of floating rates with the stability of fixed rates, which is why most countries use it today.
Q3. Using the open-economy income model, explain why the multiplier is smaller and show with the data C = 50 + 0.8Y, I = 100, G = 50, X = 40, M = 10 + 0.1Y how equilibrium income is found.
ANSWERIn an open economy, demand for domestic goods is C + I + G + X − M. A rise in autonomous expenditure raises income and induces consumption, but part of the induced consumption is spent on imported goods, which is an extra leakage from the domestic circular flow. So the induced effect on domestic income at each round is smaller, and the multiplier 1/(1 − c + m) is smaller than the closed-economy 1/(1 − c). Worked example: Y = 50 + 0.8Y + 100 + 50 + 40 − (10 + 0.1Y). So Y = 230 + 0.7Y ⇒ 0.3Y = 230 ⇒ Y = 766.67. The multiplier here is 1/(1 − 0.8 + 0.1) = 1/0.3 ≈ 3.33, compared with the closed-economy value 1/(1 − 0.8) = 5; the marginal propensity to import of 0.1 has reduced the multiplier from 5 to 3.33.
MCQs & Assertion–Reason
1. The Balance of Payments records transactions between:
(a) two firms within a country (b) residents of a country and the rest of the world (c) the government and households (d) banks and the central bank
2. The balance of trade includes only:
(a) services (b) transfers (c) exports and imports of goods (d) capital flows
3. Purchase of a foreign company by an Indian is recorded in the capital account as a:
(a) credit item (b) debit item (c) transfer payment (d) current account item
4. A current account deficit must be financed by:
(a) a capital account surplus or a fall in reserves (b) a higher trade surplus (c) more transfer payments (d) a fall in exports
5. Official reserve transactions are the accommodating item and are most relevant under:
(a) a flexible exchange rate (b) a fixed exchange rate (c) barter trade (d) autarky
6. A market-driven fall in the value of the rupee under a flexible system is called:
For each Assertion–Reason question, choose: (A) Both true and the Reason correctly explains the Assertion; (B) Both true but the Reason is not the correct explanation; (C) Assertion true, Reason false; (D) Assertion false, Reason true.
A-R 1. Assertion: The open-economy multiplier is smaller than the closed-economy multiplier.
Reason: Imports are an additional leakage from the circular flow at each round of the multiplier.
A-R 2. Assertion: Depreciation and devaluation are exactly the same thing.
Reason: Depreciation occurs through market forces under a flexible system, while devaluation is a deliberate government action under a fixed system.
A-R 3. Assertion: A current account deficit is always a cause for alarm.
Reason: A deficit financed by borrowing for productive investment can raise future output and be repaid later.
A-R 4. Assertion: Under managed floating, official reserve transactions are not equal to zero.
Reason: The central bank intervenes to moderate excessive fluctuations in the exchange rate.
A-R 5. Assertion: The real exchange rate is more relevant than the nominal rate for deciding between domestic and foreign goods.
Reason: The real exchange rate measures the relative price of foreign goods in terms of domestic goods.
Answer key: 1-(A), 2-(D), 3-(D), 4-(A), 5-(A).
Exam Tips & Common Mistakes
How to score full marks in this chapter
Learn the BoP structure precisely — current account (BOT + net invisibles), capital account, and errors & omissions — and the identity that a current-account deficit is financed by a capital-account surplus or reserve change. For numericals, always show the equilibrium condition Y = C + I + G + X − M, substitute the consumption and import functions, and solve for Y; then compute the multiplier 1/(1 − c + m) and use NX = X − M for the net export balance. Memorise the real exchange rate formula R = ePf/P and the PPP rule (new rate = old rate × ratio of price levels). Keep the four ‘-ation’ terms straight: depreciation/appreciation (market, flexible) versus devaluation/revaluation (government, fixed).
Common mistakes to avoid
Confusing balance of trade (goods only) with current account balance (goods + invisibles + transfers).
Mixing up depreciation (flexible, market) with devaluation (fixed, government) — and their opposites.
Inverting the nominal rate: if 1.25 yen = 1 rupee, the price of a yen in rupees is 1/1.25 = 0.8, not 1.25.
Forgetting that imports depend on income (M = M̄ + mY), so net exports change when equilibrium income changes.
Using the closed-economy multiplier 1/(1 − c) for an open economy instead of 1/(1 − c + m).
Treating every current account deficit as bad — it depends on size, persistence and the use of borrowed funds.
Frequently Asked Questions
What is Chapter 6 of Class 12 Economics (Introductory Macroeconomics) about?
Chapter 6, Open Economy Macroeconomics, explains how an economy links with the world through the output, financial and labour markets, records those links in the Balance of Payments (current and capital accounts), and shows how the foreign exchange rate is determined under flexible, fixed and managed-floating systems, including the PPP theory and the open-economy multiplier.
How do you solve the open-economy equilibrium income numericals in this chapter?
Set demand for domestic goods equal to income: Y = C + I + G + X − M, substitute the consumption function (with disposable income Y − T) and the import function M = M̄ + mY, then collect the Y terms and solve. The multiplier is 1/(1 − c + m) for lump-sum taxes and 1/[1 − c(1 − t) + m] for proportional taxes; net exports are NX = X − M at the equilibrium income.
What is the difference between depreciation and devaluation?
Depreciation is a market-driven fall in the value of a currency under a flexible exchange rate system, while devaluation is a deliberate government decision to lower the currency’s value under a fixed exchange rate system. In both cases the domestic currency becomes cheaper, but the cause differs.
