Under a flexible exchange rate, India’s aggregate demand grows faster than that of the rest of the world, other things remaining equal. What is the likely result?
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → The rupee depreciates, and the rupee-dollar exchange rate rises.
When India’s demand grows faster, its imports grow faster than its exports. The demand for dollars rises faster than their supply, so more rupees are needed per dollar.
A rise in the rupee-dollar rate under a flexible system is a depreciation of the rupee. Devaluation is the word for a rise in the rate set by the government under a fixed exchange rate, so it does not fit here.
NCERT (2026-27): “Income and the Exchange Rate … 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. Its demand curve for foreign currency shifts faster than its supply curve.” “Flexible Exchange Rate … Increase in exchange rate implies that the price of foreign currency (dollar) in terms of domestic currency (rupees) has increased. This is called Depreciation of domestic currency (rupees) in terms of foreign currency (dollars).” “Fixed Exchange Rates … In a fixed exchange rate system, when some government action increases the exchange rate (thereby, making domestic currency cheaper) is called Devaluation. …” |