The correct option is 2 and 3 only.
Explanation
Under a flexible exchange rate regime, the value of a currency is determined by the market forces of demand and supply. Domestic income levels directly influence the propensity to import, which is a primary driver of the demand for foreign exchange.
Statement-wise Analysis:
- Statement 1 is Incorrect. When domestic income increases, consumers have higher disposable income and purchasing power. This typically leads to an increase in overall consumption, including the consumption of imported goods. Consequently, spending on imports increases rather than decreases.
- Statement 2 is Correct. To purchase more imported goods, domestic residents must exchange their domestic currency for foreign currency. This results in a higher demand for foreign exchange at any given exchange rate. Graphically, this is represented by a rightward shift of the demand curve for foreign exchange.
- Statement 3 is Correct. If the supply of foreign exchange remains unchanged, the rightward shift in the demand curve leads to a new equilibrium with a higher price for foreign currency. A rise in the price of foreign currency (e.g., needing more Rupees to buy one Dollar) indicates a depreciation of the domestic currency.
Key Takeaway:
An increase in domestic income stimulates demand for imports, which raises the demand for foreign currency, leading to a depreciation of the domestic currency in a floating exchange rate system.