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.

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

Depciates.

Appreciates.

May or may not depreciate.

Initially appreciates and then depreciate.

✅ Correct Option: 3

Option 1 -> When only domestic income increases, imports rise, causing depreciation.

Option 2 -> When only foreign income increases, exports rise, causing appreciation.

Option 3 -> When both incomes increase simultaneously, two opposing forces act on the currency - the net effect is indeterminate.

Option 4 -> There is no theoretical basis for this specific sequential pattern.

Hence, Option 3: May or may not depreciate -> When domestic income increases, demand for imports rises, increasing demand for foreign currency (depreciation pressure). When foreign income increases, demand for exports rises, increasing demand for domestic currency (appreciation pressure). Since both occur simultaneously, the net effect on the exchange rate depends on the relative magnitudes of income changes and marginal propensities to import in both countries. If domestic income effect dominates, currency depreciates; if foreign income effect dominates, currency appreciates. Therefore, the outcome is indeterminate without knowing these relative magnitudes. -> 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 44

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

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

Solution

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