The USA raises the tariffs on goods imported from India. India has a flexible exchange rate, and other things remain the same. What is the likely effect in India’s foreign exchange market?
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → The supply curve of dollars shifts to the left, and the rupee depreciates.
A tariff is a tax on imported goods, so the US tariff makes Indian goods costlier in the American market. Americans buy fewer Indian goods, and India’s exports fall.
Exports are a source of the supply of foreign exchange. With fewer exports, fewer dollars flow into India, so the supply curve of dollars shifts to the left. At the old rate, the demand for dollars is now more than the supply, and the rupee price of the dollar rises. This rise is a depreciation of the rupee.
Option (1) The demand curve for dollars shifts to the left, and the rupee appreciates. — Incorrect. The demand for dollars comes from India’s purchases of foreign goods, gifts sent abroad and purchases of foreign assets. The US tariff does not cut these.
Option (2) The supply curve of dollars shifts to the right, and the rupee appreciates. — Incorrect. The supply curve shifts to the right when India’s exports rise, for example when income abroad increases. Here exports fall.
Option (3) The supply curve of dollars shifts to the left, and the rupee depreciates. — Correct. Fewer exports mean fewer dollars supplied, and the rupee loses value.
Option (4) The demand curve for dollars shifts to the right, and the rupee depreciates. — Incorrect. The demand curve shifts to the right when Indians buy more foreign goods and services, such as more travel abroad. The rupee would then depreciate, but for a different reason.
This question uses the foreign exchange market from Open Economy Macroeconomics with the idea of a tariff from Indian Economy 1950-1990.
NCERT (2026-27): “Supply of Foreign Exchange Foreign currency flows into the home country due to the following reasons: exports by a country lead to the purchase of its domestic goods and services by the foreigners; foreigners send gifts or make transfers; and, the assets of a home country are bought by the foreigners. A rise in price of foreign exchange will reduce the foreigner’s cost (in terms of USD) while purchasing products from India, other things remaining constant. …” “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. …” “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).” Indian Economy 1950-1990 (Indian Economic Development, Chapter 2): “… Tariffs are a tax on imported goods; they make imported goods more expensive and discourage their use. …” |