Question

Suppose inflations expectations increased in an open market economy.

1- how does it affect nominal exchange rate in the short run? (increases, decreases, or stays the same)

2- how does it affect real exchange rate in the short run? (increases, decreases, or stays the same)

Explain. Assume that the country is operating under floating exchange rate regime.

Answer 1

When Inflation is high, central bankers will often to increase interest rate in order to show the economy down and bring inflation back into an acceptable range. Whenever interest rate go up , it become more attractive for foreign investors to move funds into the country for deposit and to buy bonds.

TO DO SO, they need to purchase countries currency . If the increase demand for the currency is large enough, it would then trigger an appreciation in the currency exchange rate . In short high inflation often bring Higher interest rate.which would then a cause a shortage currency .

The exchange rate between currencies depends on the interest rate that can be earned on deposits of those currencies and the expected future exchange rate.

In floating exchange rate are in place , The domestic currency will depreciate with respect to other currency.The long term effect of money supply increase will be inflation, if GDP growth does not rise fast enough to keep up with the increase in money.