Question

Read the following statements carefully:
Statement 1: Under the flexible exchange rate system, a deficit or surplus in the Balance of Payments is automatically corrected.
Statement 2: Under the flexible exchange rate system, there is always a possibility of over/under valuation of currency.
In the light of the above given statements, choose the correct option from the following:

• A. Statement 1 is true and Statement 2 is false.
• B. Statement 1 is false and Statement 2 is true.
• C. Both Statements 1 and 2 are true.
• D. Both Statements 1 and 2 are false.

Hint:

Flexible exchange rate system ensures automatic correction of external imbalances but may lead to frequent fluctuations in currency value.

Answer 1

The Correct Option is C

Step 1: Understanding the Concept:
A flexible (floating) exchange rate system is determined by the market forces of demand and supply of foreign exchange.
Step 2: Detailed Explanation:
Statement 1 is True: In a flexible system, if there is a BoP deficit (excess demand for foreign currency), the exchange rate rises (depreciation of domestic currency).
This makes exports cheaper and imports costlier, eventually correcting the deficit. The reverse happens for a surplus.
Statement 2 is False: Overvaluation or undervaluation is a characteristic of a Fixed Exchange Rate System, where the government sets a rate different from the market equilibrium.
In a purely flexible system, the currency is always at its market-clearing value, so "official" over/under valuation does not exist in the same sense.
Step 3: Final Answer:
Statement 1 is correct regarding the self-correcting nature of BoP, while Statement 2 is incorrect as it describes a fixed rate problem.