Under a flexible exchange rate, incomes rise both in India and abroad. As a result, India’s exports grow faster than its imports, other things remaining equal. What is the likely effect on the rupee?
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → It appreciates, because the supply curve of foreign exchange shifts out by more than the demand curve shifts right.
Higher income at home raises spending on imports, so the demand curve for foreign exchange shifts right. Higher income abroad raises our exports, so the supply curve shifts out. The result depends on whether exports grow faster than imports; here they do, so supply rises by more, the price of foreign exchange falls and the rupee gains value.
Option (2) It depreciates, because higher income at home raises spending on imports. — Incorrect. Imports do rise, but exports rise faster, so the supply of foreign exchange grows by more than its demand.
Option (3) It does not change, because exports and imports both rise. — Incorrect. Both rise, but not by the same amount; the bigger rise in supply lowers the price of foreign exchange.
Option (4) It appreciates, because higher income at home lowers the demand for foreign exchange. — Incorrect. Higher income at home raises spending on imports and so raises the demand for foreign exchange.
NCERT (2026-27): “Income and the Exchange Rate 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. Its demand curve for foreign currency shifts faster than its supply curve.” |