Balance of Payments & Forex MCQs for UPSC Prelims

85 practice questions on Balance of Payments & Forex from the Economy section of the UPSC Prelims syllabus. 85 come with a written explanation and 21 are actual previous year questions. Try the sample set below - the answer stays hidden until you ask for it.

9 Easy 50 Medium 26 Hard 21 from past papers

Sample questions

Q1
Previous year question easy

Convertibility of rupee implies

  1. A being able to convert rupee notes into gold
  2. B allowing the value of rupee to be fixed by market forces
  3. C freely permitting the conversion of rupee to other currencies and vice versa
  4. D developing an international market for currencies in India
Show answer and explanation

Correct answer: C - freely permitting the conversion of rupee to other currencies and vice versa

Convertibility means the rupee can be freely exchanged for foreign currencies and foreign currencies for rupees; India adopted full current account convertibility in 1994, while capital account convertibility remains partial. Conversion of notes into gold describes the long-abandoned gold standard, not convertibility in the modern sense. Letting market forces determine the rupee's value describes a floating exchange rate regime, which is a separate concept from convertibility. Developing an international currency market in India concerns market infrastructure and is not what convertibility means.

Q2
Previous year question hard

Consider the following statements: 1. Tight monetary policy of US Federal Reserve could lead to capital flight. 2. Capital flight may increase the interest cost of firms with existing External Commercial Borrowings (ECBs). 3. Devaluation of domestic currency decreases the currency risk associated with ECBs. Which of the statements given above are correct?

  1. A 1 and 2 only
  2. B 2 and 3 only
  3. C 1 and 3 only
  4. D 1, 2 and 3
Show answer and explanation

Correct answer: A - 1 and 2 only

When the US Fed tightens, higher US yields pull capital out of emerging markets, causing capital flight, so statement 1 is correct. The resulting outflows raise borrowing costs and refinancing risk for firms carrying ECBs, so statement 2 is correct. Devaluation of the rupee actually increases the cost of repaying foreign-currency ECBs and therefore raises, not lowers, currency risk, making statement 3 wrong. Hence only 1 and 2 are correct.

Q3
Previous year question medium

With reference to the international trade of India at present, which of the following statements is/are correct? 1. India's merchandise exports are less than its merchandise imports. 2. India's imports of iron and steel, chemicals, fertilisers and machinery have decreased in recent years. 3. India's exports of services are more than its imports of services. 4. India suffers from an overall trade/current account deficit. Select the correct answer using the code given below:

  1. A 1 and 2 only
  2. B 2 and 4 only
  3. C 3 only
  4. D 1, 3 and 4 only
Show answer and explanation

Correct answer: D - 1, 3 and 4 only

Statements 1, 3 and 4 are correct: India's merchandise exports are smaller than its merchandise imports, India is a net exporter of services, and India runs an overall trade and current account deficit. Statement 2 is wrong because imports of iron and steel, chemicals, fertilisers and machinery have not decreased; such capital and intermediate imports have generally risen. Hence the answer is 1, 3 and 4 only. Note: UPSC dropped this question in the official 2020 answer key, so no marks were awarded; the option marked correct reflects the most widely accepted coaching key (1, 3 and 4).

Q4
Previous year question hard

Consider the following actions which the Government can take: 1. Devaluing the domestic currency. 2. Reduction in the export subsidy. 3. Adopting suitable policies which attract greater FDI and more funds from FIIs. Which of the above action/actions can help in reducing the current account deficit?

  1. A 1 and 2
  2. B 2 and 3
  3. C 3 only
  4. D 1 and 3
Show answer and explanation

Correct answer: D - 1 and 3

Devaluing the domestic currency makes exports cheaper and imports dearer, improving the trade balance and thus narrowing the current account deficit (action 1). Attracting more FDI and FII inflows brings in foreign exchange that helps finance and ease the external deficit (action 3). Action 2 works the wrong way: cutting export subsidies makes exports less competitive, which would lower exports and worsen, not reduce, the current account deficit. Hence only 1 and 3 help.

Q5
Previous year question medium

Consider the following statements: The price of any currency in international market is decided by the 1. World Bank 2. demand for goods/services provided by the country concerned 3. stability of the government of the concerned country 4. economic potential of the country in question Which of the statements given above are correct?

  1. A 1, 2, 3 and 4
  2. B 2 and 3 only
  3. C 3 and 4 only
  4. D 1 and 4 only
Show answer and explanation

Correct answer: B - 2 and 3 only

A currency's exchange value reflects demand for the country's goods and services and the political stability of its government, so statements 2 and 3 are correct. The World Bank does not set exchange rates (statement 1 is wrong). Economic potential influences value only indirectly and was not accepted as a direct determinant in the official key, so statement 4 is excluded, giving 2 and 3 only as the answer.

Q6
Previous year question medium

With reference to the Indian economy, consider the following statements: 1. If the inflation is too high, Reserve Bank of India (RBI) is likely to buy government securities. 2. If the rupee is rapidly depreciating, RBI is likely to sell dollars in the market. 3. If interest rates in the USA or European Union were to fall, that is likely to induce RBI to buy dollars. Which of the statements given above are correct?

  1. A 1 and 2 only
  2. B 2 and 3 only
  3. C 1 and 3 only
  4. D 1, 2 and 3
Show answer and explanation

Correct answer: B - 2 and 3 only

When inflation is high the RBI tightens liquidity by selling government securities, not buying them, so statement 1 is wrong. To arrest a rapidly depreciating rupee, the RBI sells dollars from its reserves to boost rupee demand, making statement 2 correct. Falling US or EU rates make Indian assets relatively attractive, drawing in dollar inflows that the RBI absorbs by buying dollars to prevent excessive appreciation, so statement 3 is correct. Hence only 2 and 3 are correct.

Q7
Previous year question medium

Which of the following best describes the term 'import cover', sometimes seen in the news?

  1. A It is the ratio of value of imports to the Gross Domestic Product of a country
  2. B It is the total value of imports of a country in a year
  3. C It is the ratio between the value of exports and that of imports between two countries
  4. D It is the number of months of imports that could be paid for by a country's international reserves
Show answer and explanation

Correct answer: D - It is the number of months of imports that could be paid for by a country's international reserves

Import cover measures how many months of imports a country can finance using its foreign exchange reserves, serving as an indicator of external-sector strength. It is not the imports-to-GDP ratio, the annual import value, or the export-import ratio between two countries, so those options are wrong. Hence the months-of-imports definition is correct.

Q8
Previous year question medium

In the context of India, which of the following factors is/are contributor/contributors to reducing the risk of a currency crisis? 1. The foreign currency earnings of India's IT sector 2. Increasing the government expenditure 3. Remittances from Indians abroad Select the correct answer using the code given below.

  1. A 1 only
  2. B 1 and 3 only
  3. C 2 only
  4. D 1, 2 and 3
Show answer and explanation

Correct answer: B - 1 and 3 only

Foreign currency earnings of the IT sector and remittances from Indians abroad are steady inflows that strengthen the current account and build foreign exchange reserves, reducing the risk of a currency crisis, so factors 1 and 3 are contributors. Increasing government expenditure widens the fiscal deficit, can fuel inflation and import demand, and tends to heighten rather than reduce external vulnerability, so factor 2 is not a contributor. Hence 1 and 3 only.

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