Question

Under flexible exchange rate, when the price of domestic currency in terms of foreign currency increases, it is called_______

• A. Depreciation of domestic currency
• B. Appreciation of domestic currency
• C. Devaluation of domestic currency
• D. Revaluation of domestic currency

Answer 1

The Correct Option is B

Under a flexible exchange rate system, the value of a currency is determined by market forces such as supply and demand relative to other currencies. When the price of a domestic currency in terms of foreign currency increases, it means that you now need less of the foreign currency to buy the same amount of domestic currency. This scenario is referred to as the appreciation of the domestic currency. 

Let's break down the concept:

1. Exchange Rate Definition: The exchange rate is the price of one currency in terms of another currency.

2. Flexible Exchange Rate System: Under this system, exchange rates are primarily determined by market forces without direct government or central bank intervention.

3. Appreciation Explanation: If the exchange rate moves from 1 USD = 50 INR to 1 USD = 45 INR, the domestic currency (INR) has appreciated relative to the USD. Here, the INR has become stronger, as fewer INR are needed to purchase 1 USD.

This understanding helps us identify the correct answer, which is Appreciation of domestic currency.

Answer 2

Appreciation refers to an increase in the value of a country’s domestic currency relative to foreign currencies in a flexible exchange rate system. In such a system, currency values are determined by market forces, such as supply and demand, without direct government intervention.

When a currency appreciates, it means that it can buy more of foreign currencies, making imports cheaper and potentially reducing inflationary pressures. For instance, if the value of the Indian Rupee appreciates against the U.S. Dollar, Indian consumers will find it less expensive to purchase goods from the U.S.

Appreciation can occur due to factors such as an increase in demand for a country's goods and services, higher foreign investment, or favorable interest rates. While currency appreciation can benefit consumers and importers, it may hurt exporters by making their goods more expensive for foreign buyers, potentially reducing export demand.

In contrast, a depreciation of the currency would occur when the value of the currency decreases, making exports cheaper but imports more expensive. Both appreciation and depreciation play significant roles in shaping a country's trade balance and overall economic health.