Macro

Balance of Payments

Medium

Comprehension:

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.

A country whose aggregate demand grows faster than the rest of the world's normally finds its currency______.

Appreciating.

Depreciating.

Initially appreciating and then depreciating.

Initially depreciating and then appreciating.

✅ Correct Option: 2

Option 1 -> When aggregate demand grows faster domestically, it typically leads to increased imports rather than currency appreciation.

Option 2 -> Faster aggregate demand growth increases imports to meet domestic consumption needs, creating higher demand for foreign currencies and supply of domestic currency, causing depreciation.

Option 3 -> There is no economic mechanism that would cause this initial appreciation followed by depreciation pattern in this scenario.

Option 4 -> This sequential pattern does not align with the fundamental relationship between aggregate demand growth and currency valuation.

Hence, Option 2: Depreciating -> When a country's aggregate demand grows faster than the rest of the world, domestic consumers and businesses demand more goods and services. This leads to increased imports to satisfy the excess demand that domestic production cannot meet. Higher imports require more foreign currency, increasing the supply of domestic currency in forex markets. Additionally, faster aggregate demand growth often causes higher domestic inflation relative to trading partners, making exports less competitive while imports become more attractive. This combination of increased imports and deteriorating trade balance puts downward pressure on the currency, causing it to depreciate. -> correct

Question 41

If the volume of imports of a country are growing faster than its volume of exports, its gross domestic product _______.

Question 42

Other things remaining same, if the income abroad increases, what is the likely effect of the same on national income of the domestic economy?

Question 43

A decrease in income of a country leads to?

Question 45

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

A country whose aggregate demand grows faster than the rest of the world's normally finds its currency______.

Solution

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