Question

In an efficient foreign exchange rate market, an unexpected increase in domestic money supply growth can lead to _________ .
1. An immediate appreciation of a currency
2. An immediate depreciation of a currency
3. An immediate decrease in direct foreign investment
4. None of the above

Answer 1

Correct Answer - Option 2 : An immediate depreciation of a currency

The correct answer is An immediate depreciation of a currency.

• Currency depreciation
  • It is a fall in the value of a currency in terms of its exchange rate versus other currencies.
  • Currency depreciation can occur due to factors such as economic fundamentals, interest rate differentials, political instability, or risk aversion among investors.
  • Currency depreciation is a fall in the value of a currency in a floating exchange rate system.
  • In an efficient foreign exchange rate market, an unexpected increase in domestic money supply growth can lead to an immediate depreciation of a currency. Hence, Option 2 is correct.
  • Economic fundamentals, interest rate differentials, political instability, or risk aversion can cause currency depreciation.
  • Orderly currency depreciation can increase a country’s export activity as its products and services become cheaper to buy.
  • The Federal Reserve's quantitative easing programs used to stimulate the economy in the aftermath of the 2007-2008 financial crisis caused U.S. dollar depreciation.
  • Currency depreciation in one country can spread to other countries.

• Foreign Exchange Reserves:
  • Foreign exchange reserves are assets held on reserve by a central bank in foreign currencies, which can include bonds, treasury bills, and other government securities.
  • It needs to be noted that most foreign exchange reserves are held in U.S. dollars.
  • These assets serve many purposes but are most significantly held to ensure that the central bank has backup funds if the national currency rapidly devalues or becomes altogether insolvent.
• India’s Forex Reserves include:
  • Foreign Currency Assets
  • Gold
  • Special Drawing Rights
  • Reserve position with the International Monetary Fund (IMF)