Under a flexible exchange rate, match the change in List-I with what follows in the foreign exchange market in List-II:
| List-I | List-II | ||
|---|---|---|---|
| (A) | Interest rates at home rise above those abroad | (I) | The demand curve for dollars shifts right as spending on foreign services rises |
| (B) | Indians travel abroad much more than before | (II) | The demand curve for the home currency shifts right and its supply curve shifts left |
| (C) | Investors expect the pound to appreciate against the rupee | (III) | Holding the foreign currency for an expected gain raises its demand now, and the belief becomes self-fulfilling |
| (D) | Over the long run, prices in India rise faster than prices in the US | (IV) | The exchange rate adjusts so that the same product costs the same in both countries |
Choose the correct answer from the options given below:
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → (A) - (II), (B) - (I), (C) - (III), (D) - (IV)
Under a flexible rate, the exchange rate moves whenever demand or supply in the foreign exchange market shifts. Each change in List-I works through a different channel.
| List-I | List-II | Reason |
|---|---|---|
| (A) Interest rates at home rise above those abroad | (II) The demand curve for the home currency shifts right and its supply curve shifts left | Foreign investors buy the home currency to earn the higher interest, and home investors sell less of it, so the home currency appreciates. |
| (B) Indians travel abroad much more than before | (I) The demand curve for dollars shifts right as spending on foreign services rises | Travel abroad is an import of services, paid for in foreign currency, so the rupee depreciates. |
| (C) Investors expect the pound to appreciate against the rupee | (III) Holding the foreign currency for an expected gain raises its demand now, and the belief becomes self-fulfilling | This is speculation: buying pounds today raises the rupee-pound rate today. |
| (D) Over the long run, prices in India rise faster than prices in the US | (IV) The exchange rate adjusts so that the same product costs the same in both countries | This is purchasing power parity: in the long run the rate reflects the difference in price levels. |
NCERT (2026-27): “Flexible Exchange Rate … Suppose the demand for foreign goods and services increases (for example, due to increased international travelling by Indians), then as depicted in Fig. 6.2, the demand curve shifts upward and right to the original demand curve. …” “Speculation … This expectation would increase the demand for pounds and cause the rupee-pound exchange rate to increase in the present, making the beliefs self-fulfilling.” “Exchange Rates in the Long Run The purchasing Power (PPP) theory is used to make long-run predictions about exchange rates in a flexible exchange rate system. According to the theory, as long as there are no barriers to trade like tariffs (taxes on trade) and quotas (quantitative limits on imports), exchange rates should eventually adjust so that the same product costs the same whether measured in rupees in India, or dollars in the US, yen in Japan and so on, except for differences in transportation. Over the long run, therefore, exchange rates between any two national currencies adjust to reflect differences in the price levels in the two countries.” “Interest Rates and the Exchange Rate … Investors from country A will be attracted by the high interest rates in country B and will buy the currency of country B selling their own currency. At the same time investors in country B will also find investing in their own country more attractive and will therefore demand less of country A’s currency. This means that the demand curve for country A’s currency will shift to the left and the supply curve will shift to the right causing a depreciation of country A’s currency and an appreciation of country B’s currency. Thus, a rise in the interest rates at home often leads to an appreciation of the domestic currency. …” |