Under a flexible exchange rate, the price of the dollar is set where the demand for dollars meets the supply, just as a market price is set where demand meets supply. If, at the current rate, the demand for dollars is greater than the supply, the exchange rate (rupees per dollar) will:
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → rise, and the rupee will depreciate
A flexible exchange rate is a market price. When demand for dollars is greater than supply, buyers bid up the price of the dollar, so the rate rises.
More rupees per dollar means the rupee has lost value: it has depreciated. The government does not step in under a flexible rate.
This question uses Market Equilibrium and Open Economy Macroeconomics together.
NCERT (2026-27): “Flexible Exchange Rate This exchange rate is determined by the market forces of demand and supply. …” “… 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).” Market Equilibrium (Introductory Microeconomics): “Out-of-equilibrium Behaviour From the time of Adam Smith (1723-1790), it has been maintained that in a perfectly competitive market an ‘Invisible Hand’ is at play which changes price whenever there is imbalance in the market. Our intuition also tells us that this ‘Invisible Hand’ should raise the prices in case of ‘excess demand’ and lower the prices in case of ‘excess supply’. …” |