“Under the flexible exchange rate system, the Central Bank does not intervene in the foreign exchange market.” Justify the statement, giving valid arguments. Explain the impact of home currency depreciation on the exports of a nation.

Question

Accepted Answer

Yes, under the flexible exchange rate system, the Central Bank does not intervene in the foreign exchange market. The exchange rate is determined solely by the market forces of demand and supply. This is known as a 'clean float' where the currency's value fluctuates freely based on market conditions.

Impact of home currency depreciation: When the domestic currency depreciates (e.g., ₹81/$1 rises to ₹82/$1), it leads to: (1) Increase in exports — domestic goods become cheaper for foreign buyers, (2) Decrease in imports — foreign goods become more expensive for domestic buyers, and (3) Increase in national income — due to rise in net exports (exports minus imports).