Read the passage carefully and answer the questions based on the passage:

Income and the Exchange Rate

When income of a country 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.

If the income of the country and income abroad increase simultaneously, then the domestic currency will ............

May or may not depreciate.

The correct answer is Option (3) → May or may not depreciate.

The passage says: "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."

When domestic income increases, people in the country buy more imported goods, which increases the demand for foreign exchange, leading to depreciation of the domestic currency.

At the same time, if income abroad also increases, foreigners buy more exports from the domestic country, increasing the supply of foreign exchange, which tends to appreciate the domestic currency.

Since both forces act in opposite directions, the net effect depends on which change is stronger —

• If imports grow faster than exports, the domestic currency depreciates.

• If exports grow faster than imports, it appreciates.

Hence, when both incomes rise simultaneously, the domestic currency may or may not depreciate.