Consider the effect of income on the exchange rate. If domestic income increases: 1. Consumer spending on imported goods decreases significantly. 2. The demand curve for foreign exchange shifts to the right. 3. The domestic currency is likely to depreciate. Which of the statements given above is/are correct?

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.

Consider the effect of income on the… - NCERT Class 12 Economics MCQ

NCERT Class 12 Economics — Chapter 8: Open Economy Macroeconomics

mcqmedium

Consider the effect of income on the exchange rate. If domestic income increases:

Consumer spending on imported goods decreases significantly.
The demand curve for foreign exchange shifts to the right.
The domestic currency is likely to depreciate.

Which of the statements given above is/are correct?

NCERT textbook question

From NCERT Introductory Macroeconomics · Page 9

Options

A2 and 3 only
B1, 2 and 3
C2 only
D1 and 2 only

Did you get this right?

Solution

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.

Your note

More from Chapter 8: Open Economy Macroeconomics

With reference to 'Transfer Payments' in the Balance of Payments, consider the following statements: 1. They require the recipient to provide goods or services in return. 2. They are receipts which the residents of a country get for free. 3. They consist exclusively of payments made for the import of capital goods. Which of the statements given above is/are correct?

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In a fixed exchange rate system, if there is an excess supply of foreign currency, the Central Bank must:

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Which of the following items are included in the 'Current Account' of the Balance of Payments? 1. Export of goods 2. Import of services 3. Remittances and grants 4. External Commercial Borrowings

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Consider the following statements regarding the Balance of Trade (BOT): 1. It is the difference between the value of exports and imports of goods only. 2. Export of goods is entered as a debit item in BOT. 3. A Trade Deficit arises if a country imports more goods than it exports. Which of the statements given above is/are correct?

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With reference to "Speculation" in the foreign exchange market, consider the following statements: 1. If investors expect a foreign currency to appreciate, they will demand more of it in the present. 2. Expectations of currency appreciation have no impact on the actual exchange rate. 3. Speculation can destabilize the exchange rate by amplifying market forces. Which of the statements given above is/are correct?

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