NCERT Solutions For Class 12 Economics Chapter 6 Open Economy Macroeconomics - 2025-26

1. Differentiate between balance of trade and current account balance.
The “balance of trade” means the difference between exports and imports of goods only. The current account balance includes the balance of trade along with other items like services, income, and transfers. So, the current account balance is a broader concept than just balance of trade.

2. What are official reserve transactions? Explain their importance in the balance of payments.
Official reserve transactions are central bank activities which change its reserves of foreign currency. These usually happen when the central bank buys or sells its own currency for foreign currencies. Buying its own currency is a credit (+), selling is a debit (-) in the balance of payments.

• They help stabilize the exchange rate by managing the supply of foreign currency.
• Official reserve transactions show how imbalances in the balance of payments are settled.
• When there is a BoP deficit, the central bank uses reserves to cover the gap. When there is a surplus, it adds to reserves.

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.
Summary: Nominal exchange rate measures how much domestic currency is needed for one unit of foreign currency. Real exchange rate compares the price of foreign goods to domestic goods, taking into account both exchange rates and inflation.

• Nominal exchange rate: The cost of one unit of foreign currency in domestic currency (e.g., 50 rupees per dollar).
• Real exchange rate: The price of foreign goods in terms of domestic goods. Shows true cost after accounting for price levels in both countries.
• If you have to choose between domestic and foreign goods, the real exchange rate is more relevant because it reflects relative prices, not just currency conversion.
• Formula: Real exchange rate = Nominal exchange rate × (Foreign price level)/(Domestic price level)
• Example: If US watch = $40, nominal rate = 50, then Rs price = 50 × 40 = Rs.2000

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).
Summary: First, work out the nominal exchange rate (yen per rupee), then use the formula for the real exchange rate.

• Japan price level, $P_f$ = 3
• India price level, $P$ = 1.2
• 1 rupee = 1.25 yen, so 1 yen = 1/1.25 = 0.8 rupee
• Nominal exchange rate (e) = 0.8 rupee per yen
• Real exchange rate = e × ($P_f$/$P$) = 0.8 × 3/1.2 = 2
• So, Japanese goods are twice as expensive as Indian goods when converted.

5. Explain the automatic mechanism by which BOP equilibrium was achieved under the gold standard.
Summary: The gold standard made currency values fixed in terms of gold, and international payments were settled with gold flows.

• Each country fixed its currency value to a certain amount of gold.
• Balance of payments deficits were corrected as gold moved from deficit countries to surplus countries.
• Gold outflows reduced money supply, causing prices to fall in deficit countries, making their exports cheaper and imports pricey—helping restore balance.
• This process happened automatically without government intervention, known as the price-specie-flow mechanism.
• The fixed exchange rate system under gold standard meant only small short-term fluctuations were allowed.

6. How is the exchange rate determined under a flexible exchange rate regime?
Summary: In a flexible exchange rate system, the rate is decided by demand and supply of foreign currency in the market.

• When demand equals supply, the exchange rate is at equilibrium.
• If demand rises above supply, currency becomes expensive until balance is restored, and vice versa.
• Payments for imports, loans, and grants create demand for foreign exchange.
• Exports and investments supply foreign exchange.
• The intersection of demand and supply curves (in a diagram) fixes the rate.

7. Differentiate between devaluation and depreciation.

Devaluation	Depreciation
Occurs when, under a fixed exchange rate, the currency’s value is officially reduced.	Happens when the currency loses value compared to others under flexible exchange rates.
Exists in fixed/pegged exchange rate regimes.	Exists in floating exchange rate systems.
Due to official/government action.	Due to market forces (demand and supply).

8. Would the central bank need to intervene in a managed floating system? Explain why.
A managed floating system lets market demand and supply set exchange rates, but the central bank sometimes intervenes to stabilize the rate. The bank buys or sells foreign currency to smooth out sharp fluctuations and maintain stability. It provides for rule-based or discretionary adjustments as needed.

9. Are the concepts of demand for domestic goods and domestic demand for goods the same?
No, they differ in an open economy. Demand for domestic goods includes both domestic and foreign buyers buying Indian products. Domestic demand for goods includes all products bought in India, whether made locally or imported.

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?
Marginal propensity to import (m) is 0.06 in the equation M = 60 + 0.06Y. A higher marginal propensity to import means as income increases, more is spent on imports, reducing the impact of extra income on domestic aggregate demand.

11. Why is the open economy autonomous expenditure multiplier smaller than the closed economy one?
Summary: In an open economy, some extra spending leaks out as imports, so the multiplier is smaller.

• In a closed economy, all new spending stays inside and increases output more.
• In an open economy, part of extra income is spent on imports, so the boost to domestic output is less.
• This shows up as a larger denominator in the open economy multiplier formula, reducing its size.
• More imports mean a smaller multiplier effect from any increase in spending.

12. Calculate the open economy multiplier with proportional taxes, T = tY, instead of lump-sum taxes as assumed in the text.
Summary: With proportional taxes, the multiplier formula changes because tax reduces disposable income.

• Equilibrium income: $Y = [C + I + G + X - M]/[1-c(1-t)+m]$
• Autonomous expenditure (A) includes all spending not dependent on income.
• The open economy multiplier with proportional taxes is $1/[1-c(1-t)+m]$.
• So, tax rate and import propensity both make the multiplier smaller.

13. Suppose C=40+0.8YD, T=50, I=60, G=40, X=90, M=50+0.05Y
(a) Find equilibrium income
The equilibrium income (Y) is found by plugging values into the formula:
$A = C - cT + I + G + X - M$
$A = 40 - 0.8×50 + 60 + 40 + 90 - 50 = 40 - 40 + 60 + 40 + 90 - 50 = 140$
$1 - c + m = 1 - 0.8 + 0.05 = 0.25$
$Y = 140 / 0.25 = 560$

(b) Net exports at equilibrium income
$NX = X - M - mY = 90 - 50 - 0.05×560 = 40 - 28 = 12$

(c) When G increases from 40 to 50
$A = 40 - 0.8×50 + 60 + 50 + 90 - 50 = 40 - 40 + 60 + 50 + 90 - 50 = 150$
$1 - c + m = 1 - 0.8 + 0.05 = 0.25$
$Y = 150 / 0.25 = 600$
Net export balance: $NX = 90 - 50 - 0.05×600 = 40 - 30 = 10$

14. In the above example, if exports change to $X=100$, find the change in equilibrium income and the net export balance
$C = 40 + 0.8YD$, $T = 50$, $I = 60$, $G = 40$, $X = 100$, $M = 50 + 0.05Y$
$A = 40 - 0.8 x 50 + 40 + 60 + 100 - 50 = 40 - 40 + 40 + 60 + 100 - 50 = 150$
$1 - c + m = 1 - 0.8 + 0.05 = 0.25$
$Y = 150 / 0.25 = 600$
Net export balance: $NX = 100 - 50 - 0.05 x 600 = 50 - 30 = 20$

15. Explain why $G-T=(S^p-I)-(X-M)$
Summary: The equation links government budget balance, savings, investment, and net exports in an open economy.

• In a closed economy, savings equals investment.
• In an open economy: $Y = C + I + G + X - M$
• National savings ($S^p$ for private, $S^g$ for government) = investment + net exports
• Rearranging terms gives $G - T = (S^p - I) - (X - M)$
• This equation shows the connection between domestic budget deficit, investment, and trade balance.

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?
If country A has higher inflation than country B, but exchange rates are fixed, the goods from country A become more expensive. Country B will export more to country A, and country A will import more from country B, leading to a trade deficit for country A and a surplus for country B.

17. Should a current account deficit be a cause for alarm? Explain.
Summary: A current account deficit means a country imports more than it exports, but it's not always a problem.

• A deficit can indicate excessive inflation or low competitiveness, which might be risky.
• However, it could also show investment for future growth or building capital stock.
• It only becomes a concern if the country can't finance it sustainably.

18. Suppose C=100+0.75YD, I=500, G=750, taxes are 20 percent of income, X=150, M=100+0.2Y. Calculate equilibrium income, the budget deficit or surplus and the trade deficit or surplus.
Equilibrium income is found as:
$Y = 100 + 0.75(Y - 0.2Y) + 500 + 750 + 150 - 100 - 0.2Y$
$Y = 1400 + 0.6Y - 0.2Y$
$Y - 0.4Y = 1400$
$0.6Y = 1400$
$Y = 1400 / 0.6 = 2333.33$
Taxes = 0.2 × 2333.33 = 466.66
Budget: Expenditure = 750, Receipts = 466.66. Since expenditure > receipts, there is a budget deficit.
Net exports: $NX = 150 - 100 - 0.2 × 2333.33 = 150 - 100 - 466.67 = -416.67$, showing a trade deficit (negative NX).

19. Discuss some of the exchange rate arrangements that countries have entered into to bring about stability in their external accounts.
Summary: Countries use various exchange rate systems to keep their external accounts stable.

• Wider Bands: Small leeway in rates (e.g., up to 10% difference) to fix imbalances.
• Crawling Peg: Regular, small changes to the fixed rate (like 1% at a time).
• Managed Floating: The government intervenes when needed, but rates mostly float.
• Floating Rate: Currency value moves with supply-demand in the market (no intervention).
• Fixed Rate: Currency pegged to gold, another currency, or a basket; government commits to specific rate.
• Pegged Float: The rate hovers around a set value, with permitted fluctuations.

Devaluation	Depreciation
Occurs when, under a fixed exchange rate, the currency’s value is officially reduced.	Happens when the currency loses value compared to others under flexible exchange rates.
Exists in fixed/pegged exchange rate regimes.	Exists in floating exchange rate systems.
Due to official/government action.	Due to market forces (demand and supply).