Exchange Rate Systems And Forex Market

Statement 1 is incorrect: The World Bank is an international financial institution that provides loans to low and middle-income countries for capital projects. It does not intervene in the international market to "decide" or set the price of currencies. Statement 2 is correct: This is a fundamental of the Current Account. If there is high demand for a country’s exports (goods and services), international buyers must purchase that country’s currency to pay for them, driving up the currency's price. Statement 3 is correct: This is a fundamental of the Capital Account. Political stability attracts Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI). If a government is unstable, investors pull out their capital, leading to a surplus of the currency in the market and a drop in its price. Statement 4 is considered a secondary factor: While "economic potential" attracts long-term investment, the UPSC official key for this question traditionally excludes it as a direct decider of the daily market price compared to the immediate impact of trade demand and political stability.

To stop the slide of the Rupee (depreciation), the RBI/Government needs to increase the inflow of foreign currency (USD) or decrease the outflow. Option (a), (b), and (c) are likely measures: They either increase the supply of dollars in the Indian market or reduce the demand for dollars, which helps stabilize the Rupee. Option (d) is NOT a likely measure: An expansionary monetary policy usually involves lowering interest rates. When interest rates fall, the "carry trade" becomes less attractive to foreign investors, leading to capital flight. This increases the supply of Rupee in the market and decreases its value further. To stop a slide, the RBI typically follows a contractionary (dear money) policy to attract capital and curb inflation.

**Statement 1 is correct:** Foreign currency earnings - The IT sector generates foreign exchange through exports of services. This increases the supply of foreign currency reserves, making it easier to defend the rupee's value in the foreign exchange market during times of stress. **Statement 2 is incorrect:** While government spending can stimulate economic growth, it can also lead to a higher budget deficit. If the deficit is financed by excessive borrowing, it can put pressure on the currency if investors lose confidence in the government's ability to repay its debts. **Statement 3 is correct:** Remittances from abroad - When Indians working abroad send money back home, it adds to the inflow of foreign currency. This strengthens the country's foreign exchange reserves and provides a buffer against external shocks. Therefore, the correct code is 1 and 3 only.

**Statement 1 is correct.** When a country devalues its currency, it becomes cheaper for foreign buyers to purchase the country's exports. This can lead to increased demand for exports, making domestic producers more competitive in the international market. **Statement 2 is incorrect.** Devaluation actually decreases the foreign value of the domestic currency. The whole point is to make the domestic currency less expensive relative to foreign currencies. **Statement 3 is also incorrect.** While improved export competitiveness can lead to a better trade balance (more exports, fewer imports), it's not a guaranteed outcome. Other factors like import prices, global demand, and domestic production costs can also influence the trade balance. Devaluation can also lead to increased import costs if the country relies on imported raw materials. Therefore, the correct code is 1 only.

**Statement 1 is correct:** The Federal Reserve's monetary policy decisions, particularly regarding interest rates, can impact global capital flows. If the Fed raises interest rates, it can make US investments more attractive, potentially leading to some outflow of capital from India. This could affect demand for Indian government bonds and influence their yield. **Statement 2 is correct:** The RBI's monetary policy plays a crucial role in influencing Indian government bond yields. The RBI's actions like setting repo rates, open market operations, and cash reserve ratio (CRR) can affect the overall liquidity in the banking system. Higher liquidity can lead to lower yields, and vice versa. **Statement 3 is correct:** Inflation expectations and short-term interest rates are important factors for investors when considering the return on government bonds. Higher inflation expectations can lead investors to demand higher yields to compensate for the potential erosion of purchasing power. Similarly, short-term interest rates can act as a benchmark for bond yields. Therefore, all three factors significantly influence the yields of Indian government bonds.

* **Statement 1 is correct.** The nominal Effective Exchange Rate (NEER) is a measure of the value of a country's currency against a basket of other currencies weighted by their importance in trade. If NEER increases, it means that the value of the currency has increased relative to the currencies in the basket, indicating appreciation. * **Statement 2 is incorrect.** The Real Effective Exchange Rate (REER) takes into account both nominal exchange rates and relative price levels (inflation) between countries. An increase in REER means that the country's currency is overvalued relative to its trading partners, which can reduce trade competitiveness. * **Statement 3 is correct.** If domestic inflation is higher than inflation in other countries, the real value of the domestic currency decreases faster than the nominal value, causing a divergence between NEER and REER. Therefore, the correct statements are 1 and 3.

* Sterilisation refers to the actions taken by a central bank to offset the impact of its foreign exchange operations on the domestic money supply. * When a central bank intervenes in the foreign exchange market by buying or selling foreign currencies, it affects the domestic money supply. * Open Market Operations (OMO) is one of the primary tools used by central banks, including the Reserve Bank of India (RBI), to conduct monetary policy. * In OMO, the central bank buys or sells government securities (bonds) in the open market to influence the liquidity in the economy. When the RBI conducts OMO, it impacts the money supply in the economy. If the RBI buys government securities, it injects money into the system, increasing the money supply. To prevent this injection of money from creating inflationary pressures, the RBI engages in sterilisation. * Sterilisation involves the simultaneous sale or purchase of other securities, typically treasury bills, to offset the impact of the initial open market operation.