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Q38 (IAS/2021) Economy › External Sector & Trade › Exchange rate dynamics Official Key

Consider the following statements: The effect of devaluation of a currency is that it necessarily 1. improves the competitiveness of the domestic exports in the foreign markets 2. increases the foreign value of domestic currency 3. improves the trade balance Which of the above statements is/are correct?

Result
Your answer: —  ·  Correct: A
Explanation

The correct answer is Option 1 (1 only).

Devaluation involves a deliberate downward adjustment of a country's currency value relative to foreign currencies. This makes domestic goods cheaper for foreign buyers, thereby necessarily improving the competitiveness of domestic exports in international markets (Statement 1).

  • Statement 2 is incorrect because devaluation, by definition, decreases the foreign value of the domestic currency, making it weaker against others.
  • Statement 3 is not necessarily correct. While devaluation aims to improve the trade balance, its success depends on the Marshall-Lerner condition (the price elasticity of demand for exports and imports). If the demand is inelastic, or if the cost of essential imported raw materials rises significantly, the trade balance may actually worsen, as seen in the "J-curve" effect.

Since statement 1 is the only outcome that occurs by default through the mechanism of price reduction, 1 only is the most accurate choice.

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Don’t just practise – reverse-engineer the question. This panel shows where this PYQ came from (books / web), how the examiner broke it into hidden statements, and which nearby micro-concepts you were supposed to learn from it. Treat it like an autopsy of the question: what might have triggered it, which exact lines in the book matter, and what linked ideas you should carry forward to future questions.
Q. Consider the following statements: The effect of devaluation of a currency is that it necessarily 1. improves the competitiveness of th…
At a glance
Origin: Books + Current Affairs Fairness: Moderate fairness Books / CA: 6.7/10 · 3.3/10

This is a classic 'Mechanism vs. Outcome' trap. UPSC tests if you distinguish between the immediate price effect (competitiveness) and the conditional final result (trade balance). The word 'necessarily' is the key filter—it validates the definition (S1) but invalidates the conditional outcome (S3).

How this question is built

This question can be broken into the following sub-statements. Tap a statement sentence to jump into its detailed analysis.

Statement 1
Does devaluation of a country's currency necessarily improve the competitiveness of that country's domestic exports in foreign markets?
Origin: Direct from books Fairness: Straightforward Book-answerable
From standard books
Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 16: Balance of Payments > Measures taken by the Government/RBI to overcome BOP Imbalance > p. 484
Presence: 5/5
“• Credit control measures to decrease money supply in the economy, which helps to reduce a. the purchasing power and thereby results in decrease in aggregate demand. • Devaluation of domestic currency (not always) which stimulates exports and reduces b. demand for imports. • Export promotion and import control measures such as more of export incentives and c. subsidies and restriction on imports through licensing, import quota, etc. • d. Structural reforms to put the economy on a competitive path.”
Why this source?
  • Explicitly qualifies devaluation with '(not always)', denying automatic effectiveness.
  • Presents devaluation as one measure among others to address BOP, implying conditional outcomes.
  • Links devaluation to export stimulation but frames it as a conditional, not guaranteed, tool.
Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > National Income Identity for an Open Economy > p. 97
Presence: 4/5
“A higher R makes foreign goods relatively more expensive, thereby leading to a decrease in the quantity of imports. Thus, imports depend positively on Y and negatively on R. The export of one country is, by definition, the import of another. Thus, our exports would constitute of foreign imports. It would depend on foreign income, Yf , and on R. A rise in Yf will increase foreign demand for our goods, thus leading to higher exports. An increase in R, which makes domestic goods cheaper, will increase our exports. Exports depend positively on foreign income and the real exchange rate.”
Why this source?
  • Identifies the real exchange rate as the determinant of exports and competitiveness.
  • Shows exports depend on foreign income and the real exchange rate, so nominal devaluation helps only if the real rate (and external demand) changes accordingly.
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > Before 1993: > p. 40
Presence: 4/5
“But if due to inflation the burger price in India becomes Rs. 20 then exports from India will stop (i.e., inflation in India is making its exports less competitive). But in that situation when price has increased to Rs. 20, if RBI devalues the exchange rate to $1 = Rs. 30 then again exports from India will start. Because now foreigners will get Rs. 30 in $1 and in Rs. 30 they will get one and a half burger in India. Hence, to increase its exports and improve the balance of payment situation, India consistently devalued its currency till 1993.”
Why this source?
  • Provides a concrete conditional example: domestic inflation can make exports uncompetitive and devaluation can restore competitiveness only in that situation.
  • Implicates that effectiveness of devaluation depends on underlying price levels and relative prices, not on devaluation alone.
Statement 2
Does devaluation of a country's currency necessarily increase the value of the domestic currency in terms of foreign currencies?
Origin: Web / Current Affairs Fairness: CA heavy Web-answerable

Web source
Presence: 5/5
"* Devaluation is a deliberate reduction of a country's currency value to make exports cheaper and imports more expensive."
Why this source?
  • Defines devaluation explicitly as a deliberate reduction in a country's currency value — directly contradicts the claim that devaluation would increase domestic currency value.
  • States the purpose of devaluation (make exports cheaper, imports more expensive), which implies a lower domestic-currency value versus foreign currencies.
Web source
Presence: 4/5
"because in case of currency devaluation, the burden of the former kind of debt in domestic currency terms would immediately increase, sometimes very significantly."
Why this source?
  • Explains that when currency devaluation occurs, the domestic-currency burden of foreign-denominated debt increases — showing the domestic currency has lost value relative to foreign currencies.
  • Uses devaluation to illustrate an increase in domestic-currency amounts needed for foreign obligations, which is inconsistent with an increase in domestic currency value.

Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > Fixed Exchange Rates > p. 94
Strength: 5/5
“If it fails to do so, a black market for dollars may come up. In a fixed exchange rate system, when some government action increases the exchange rate (thereby, making domestic currency cheaper) is called Devaluation. On the other hand, a Revaluation is said to occur, when the Government decreases the exchange rate (thereby, making domestic currency costlier) in a fixed exchange rate system.”
Why relevant

Gives the technical definition of devaluation in a fixed exchange rate system as a government action that increases the exchange rate (making domestic currency cheaper).

How to extend

A student can use this to infer that devaluation is an official lowering of domestic-currency value under a peg, and therefore would not 'increase' domestic value — check whether the statement confuses direction.

Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 17: India’s Foreign Exchange and Foreign Trade > WHICH EXCHANGE RATE SYSTEM SUITS AN ECONOMY BEST? > p. 494
Strength: 5/5
“As free float carries the risk of sudden capital flight and speculative attacks, it can be disastrous for an economy. Thus, a majority of countries combine features of pegged system and free float system in various degrees to follow an intermediate exchange rate regime. India also belongs to this category by following a managed float system. • Depreciation: It occurs when the value of domestic currency falls in the international exchange market. It occurs automatically through the market forces of demand and supply. Devaluation: When the value of domestic currency is deliberately reduced by the government, it is termed 'devaluation'. • Depreciation: For example, if \bar{\zeta}/\frac{4}{3} increases from \bar{\zeta}/5 per $ to ₹80 per $, it signifies depreciation.”
Why relevant

Distinguishes devaluation (deliberate reduction by government) from depreciation (market-driven fall) and defines devaluation as reducing the value of domestic currency.

How to extend

Combine with the statement to test if 'devaluation' could ever mean an increase in domestic-currency value — a student would conclude the usual meaning is the opposite and seek exceptions (different regimes).

Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > Flexible Exchange Rate > p. 92
Strength: 4/5
“This is called Depreciation of domestic currency (rupees) in terms of foreign currency (dollars). Similarly, in a flexible exchange rate regime, when the price of domestic currency (rupees) in terms of foreign currency (dollars) increases, it is called Appreciation of the domestic currency (rupees) in terms of foreign currency (dollars). This means that the”
Why relevant

Explains appreciation and depreciation terminology in terms of domestic currency price in foreign currency under flexible rates.

How to extend

Use this rule to translate between language (increase/decrease in 'price' of domestic vs foreign currency) and check whether the statement mixes up appreciation/devaluation concepts.

Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 17: India’s Foreign Exchange and Foreign Trade > LESS DEVELOPED COUNTRIES OFTEN DEVALUE THEIR CURRENCY, IS IT TRUE? > p. 495
Strength: 4/5
“Yes, Less Developed Countries often devalue their currency because: • Devaluation by the government raises the demand of domestically produced goods and services and thereby exports are expected to rise. • Rise of exports helps to raise foreign exchange flow which as a result facilitates imports of essential items. • Devaluation also attracts private foreign investment into the economy which enables a better GDP growth. In July 1991 the Indian government devalued the rupee by between 18 and 19 per cent to overcome the BOP Crisis. Black Wednesday occurred in the United Kingdom in 1992. December Mistake occurred in Mexico in 1994.”
Why relevant

Provides an example-driven pattern: devaluation is used to raise export competitiveness and increase foreign exchange inflow (implying devaluation lowers domestic value to boost exports).

How to extend

A student could map the intended effect (higher exports) to exchange-rate direction and thus judge that devaluation typically lowers domestic-currency value rather than increases it.

Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > National Income Identity for an Open Economy > p. 101
Strength: 4/5
“Deficit financing through central bank borrowing Financing of budget deficit by the government through borrowing money from the central bank. Leads to increase in money supply in an economy and may result in inflation. Depreciation A decrease in the price of the domestic currency in terms of the foreign currency under floating exchange rates. It corresponds to an increase in the exchange rate. Depreciation Wear and tear or depletion which capital stock undergoes over a period of time. Devaluation The decrease in the price of domestic currency under pegged exchange rates through official action. Double coincidence of wants A situation where two economic agents have complementary demand for each others' surplus production.”
Why relevant

Provides formal definitions linking depreciation/devaluation to decreases in domestic-currency price under different regimes, clarifying terminology.

How to extend

A student could use these definitions plus knowledge of exchange-rate regimes to assess whether the statement's claim is consistent with textbook definitions.

Statement 3
Does devaluation of a country's currency necessarily improve that country's trade balance?
Origin: Direct from books Fairness: Straightforward Book-answerable
From standard books
Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 16: Balance of Payments > IRVE > p. 486
Presence: 5/5
“The J-Curve is an economic theory which states that, under certain assumptions, a country's trade deficit will initially worsen after the depreciation of its currency - mainly because higher prices on imports will be greater than the reduced volume of imports. But as time progresses, export levels begin to dramatically increase, due to their more attractive prices to foreign buyers. Simultaneously, domestic consumers purchase less imported products, due to their higher costs. These parallel actions ultimately shift the trade balance, to present an increased surplus and smaller deficit, compared to those figures before the devaluation. The trajectory described thus gives it the shape of an umbrella stick or J.”
Why this source?
  • Explicitly describes the J‑Curve: trade deficit can initially worsen after depreciation and only improve later under certain assumptions.
  • Makes clear that improvement is conditional and not automatic immediately after devaluation.
Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > Income and the Exchange Rate > p. 93
Presence: 4/5
“When income increases, consumer spending increases. Spending on imported goods is also likely to increase. When imports increase, the demand curve for foreign exchange shifts to the right. There is a depreciation of the domestic currency. If there is an increase in income abroad as well, domestic exports will rise and the supply curve of foreign exchange shifts outward. On balance, the domestic currency may or may not depreciate. What happens will depend on whether exports are growing faster than imports. In general, other things remaining equal, a country whose aggregate demand grows faster than the rest of the world's normally finds its currency depreciating because its imports grow faster than its exports.”
Why this source?
  • Explains that changes in income (domestic and foreign) alter import and export volumes and therefore affect exchange-rate outcomes.
  • Shows that trade outcomes after a currency change depend on relative demand dynamics, so devaluation's effect is not mechanically fixed.
Geography of India ,Majid Husain, (McGrawHill 9th ed.) > Chapter 12: Transport, Communications and Trade > BALANCE OF TRADE AND BALANCE OF PAYMENT > p. 52
Presence: 3/5
“When these invisibles, both exports and imports, are brought into account, many countries which would have an unfavourable balance of trade are found to have a more favourable balance of payments. It is much more important that the total payments and receipts rather than the visible trade, should be well balanced as long-term loans may have to be obtained, which may lead to future difficulties when they have to be repaid; or gold reserves may be reduced; or overseas assets may be sold so that longer-term invisible exports are reduced; or currency values may be changed by devaluation or revaluation to alter the relative value of exports and imports and thus balance total transactions more nearly.”
Why this source?
  • Emphasises that total payments (including invisibles) matter more than visible trade alone when assessing balance adjustments.
  • Implies that devaluation is one tool among many to 'alter relative value' and does not guarantee overall trade balance improvement.
Pattern takeaway: UPSC Economics questions often hinge on the timeline of effects. A policy action has an immediate definition (Devaluation = cheaper exports) and a lagged, uncertain outcome (Trade Balance). The exam punishes aspirants who conflate the tool with the successful achievement of its goal.
How you should have studied
  1. [THE VERDICT]: Conceptual Trap (Medium). Solvable via NCERT Macroeconomics (Chapter 6), but requires handling the extreme keyword 'necessarily' with nuance.
  2. [THE CONCEPTUAL TRIGGER]: External Sector > Exchange Rate Systems > Impact of Currency Fluctuations on BOP.
  3. [THE HORIZONTAL EXPANSION]: Marshall-Lerner Condition (elasticities sum > 1), J-Curve Effect (short-term worsening vs long-term gain), NEER vs REER (inflation adjustment), Sterilization (RBI open market operations), and the 'Impossible Trinity'.
  4. [THE STRATEGIC METACOGNITION]: When studying economic tools (Repo, Devaluation, MSP), separate the 'First Order Effect' (Price changes) from the 'Second Order Effect' (Volume/Behavior changes). First order is usually 'necessary'; second order is conditional.
Concept hooks from this question
📌 Adjacent topic to master
S1
👉 Real exchange rate and export competitiveness
💡 The insight

The real exchange rate determines how price-competitive domestic goods are abroad, so a nominal devaluation improves competitiveness only if it alters the real exchange rate in favor of exporters.

High-yield for UPSC because it links exchange-rate policy to trade outcomes and balance-of-payments analysis; connects macro topics (inflation, external demand, trade balance). Mastery enables crisp answers on when currency moves affect exports and on policy efficacy questions.

📚 Reading List :
  • Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > National Income Identity for an Open Economy > p. 97
  • Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > Supply of Foreign Exchange > p. 91
🔗 Anchor: "Does devaluation of a country's currency necessarily improve the competitiveness..."
📌 Adjacent topic to master
S1
👉 Domestic inflation vs nominal devaluation
💡 The insight

Domestic inflation can offset the intended price effects of a nominal devaluation, so competitiveness improves only when devaluation outpaces domestic price rises.

Important for explaining conditional policy outcomes (why devaluation failed or succeeded historically); links to topics such as price level, competitiveness, and policy sequencing. Useful for questions on balance-of-payments crisis management and effectiveness of devaluation.

📚 Reading List :
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > Before 1993: > p. 40
  • Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 16: Balance of Payments > Measures taken by the Government/RBI to overcome BOP Imbalance > p. 484
🔗 Anchor: "Does devaluation of a country's currency necessarily improve the competitiveness..."
📌 Adjacent topic to master
S1
👉 Exchange-rate regimes: devaluation (fixed) vs depreciation (flexible)
💡 The insight

Devaluation is an official policy move under fixed regimes, whereas depreciation is market-driven under flexible regimes; the institutional context shapes how and when competitiveness is affected.

Essential for answering questions on policy tools and constraints under different regimes, and for evaluating government measures (e.g., revaluation, black markets). Helps frame policy prescriptions and historical examples in essays and mains answers.

📚 Reading List :
  • Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > Fixed Exchange Rates > p. 94
  • Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 17: India’s Foreign Exchange and Foreign Trade > Types of Exchange Rate System > p. 492
🔗 Anchor: "Does devaluation of a country's currency necessarily improve the competitiveness..."
📌 Adjacent topic to master
S2
👉 Devaluation vs Depreciation vs Appreciation
💡 The insight

Devaluation is an official reduction in the domestic currency's price under a pegged system, while depreciation and appreciation describe market-driven falls or rises in value.

High-yield: distinguishing these terms is essential for answering questions on exchange-rate policy and interpreting policy actions. It links to macroeconomic policy, balance-of-payments analysis, and forex market mechanics. Mastery allows rapid elimination of wording traps in UPSC questions about currency value changes and policy responses.

📚 Reading List :
  • Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 17: India’s Foreign Exchange and Foreign Trade > WHICH EXCHANGE RATE SYSTEM SUITS AN ECONOMY BEST? > p. 494
  • Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > National Income Identity for an Open Economy > p. 101
  • Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > Flexible Exchange Rate > p. 92
🔗 Anchor: "Does devaluation of a country's currency necessarily increase the value of the d..."
📌 Adjacent topic to master
S2
👉 Fixed (pegged) vs Flexible (floating) exchange-rate regimes
💡 The insight

Devaluation is a deliberate government action in a fixed/pegged regime; depreciation/appreciation occur automatically under flexible regimes.

High-yield: many questions ask how policy tools and outcomes differ across regimes. Understanding regime type clarifies what actions (devaluation, revaluation) are possible and their institutional mechanics. This concept bridges international macroeconomics, monetary policy, and external sector issues.

📚 Reading List :
  • Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > Fixed Exchange Rates > p. 94
  • Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 17: India’s Foreign Exchange and Foreign Trade > WHICH EXCHANGE RATE SYSTEM SUITS AN ECONOMY BEST? > p. 494
  • Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 17: India’s Foreign Exchange and Foreign Trade > Types of Exchange Rate System > p. 492
🔗 Anchor: "Does devaluation of a country's currency necessarily increase the value of the d..."
📌 Adjacent topic to master
S2
👉 Trade and foreign-exchange effects of currency value changes
💡 The insight

Changes in currency value (including devaluation) influence export competitiveness, foreign exchange flows, and import costs.

High-yield: UPSC often tests links between exchange rates and trade balance, BOP adjustment, and growth policy. Mastery helps answer applied questions on how exchange-rate moves alter exports, imports, and foreign-investment incentives.

📚 Reading List :
  • Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 17: India’s Foreign Exchange and Foreign Trade > LESS DEVELOPED COUNTRIES OFTEN DEVALUE THEIR CURRENCY, IS IT TRUE? > p. 495
  • Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > Supply of Foreign Exchange > p. 91
  • Macroeconomics (NCERT class XII 2025 ed.) > Chapter 6: Open Economy Macroeconomics > Income and the Exchange Rate > p. 93
🔗 Anchor: "Does devaluation of a country's currency necessarily increase the value of the d..."
📌 Adjacent topic to master
S3
👉 J‑Curve effect
💡 The insight

A currency depreciation can worsen the trade deficit initially and only improve later, so improvement is not automatic.

High-yield for answers on exchange rate policy and short vs long run effects; links macro policy to trade and balance of payments questions. Enables explanation of temporal dynamics in policy debates (short‑term pain vs long‑term gain).

📚 Reading List :
  • Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 16: Balance of Payments > IRVE > p. 486
🔗 Anchor: "Does devaluation of a country's currency necessarily improve that country's trad..."
🌑 The Hidden Trap

The Marshall-Lerner Condition. Since they asked *if* devaluation improves trade balance (and the answer was 'not necessarily'), the next logical question is *under what condition* does it improve? Answer: When the sum of price elasticities of demand for exports and imports is greater than 1.

⚡ Elimination Cheat Code

The 'Definition Check' Hack. Look at Statement 2: 'Increases the foreign value of domestic currency.' Devaluation literally means *decreasing* the value. This is a definitional contradiction. Eliminate Statement 2 immediately. You are left with A (1 only) and C (3 only). Between Competitiveness (Price) and Trade Balance (Volume), Price is the direct mathematical result of devaluation, while Balance depends on global demand. Choose the direct effect (Statement 1).

🔗 Mains Connection

Mains GS3 (Energy Security & CAD): Devaluation acts as a double-edged sword for India. While it boosts software/textile exports (competitiveness), it inflates the Oil Import Bill, potentially worsening the Current Account Deficit (CAD) and importing inflation (Pass-through effect).

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SIMILAR QUESTIONS

IAS · 2022 · Q31 Relevance score: 5.19

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?

CDS-II · 2023 · Q63 Relevance score: 4.66

Which of the following is/are the effects of devaluation or depreciation of currency ? 1. It leads to increase in imports and decrease in exports. 2. It leads to increase in exports and decrease in imports. 3. It leads to increase in domestic inflation. 4. It leads to decrease in domestic inflation. Select the correct answer using the code given below : (a) 1 and 3 only (b) 2 and 3 only (c) 1 and 4 only (d) 3 only

IAS · 1999 · Q99 Relevance score: 2.88

Assertion (A) : Devaluation of a currency may promote export. Reason (R) : Price of the country’s products in the international market may fall due to devaluation.

IAS · 2022 · Q92 Relevance score: 2.74

With reference to the Indian economy, consider the following statements : 1. An increase in Nominal Effective Exchange Rate (NEER) indicates the appreciation of rupee. 2. An increase in the Real Effective Exchange Rate (REER) indicates an improvement in trade competitiveness. 3. An increasing trend in domestic inflation relative to inflation in other countries is likely to cause an increasing divergence between NEER and REER. Which of the above statements are correct ?

IAS · 2011 · Q10 Relevance score: 2.42

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.