Question

Assume two open economy countries, the UK and Japan. Both the market for British Pound (GBP) and the Japanese Yen (¥) are in equilibrium. Other things equal, if the real interest rate in the UK increases, explain what happens in the markets for GBP and ¥ from the British perspective. Clearly explain which currency appreciates and which currency depreciates.

Answer 1

Answer

Assuming UK and Japan to be in equilibrium initially,

In case the real interest rate in UK goes up, it will lead to higher investments in UK as the return has now become attractive for investors. If UK receives more and more investments, it means people who want to invest in UK will start demanding more and more British Pound (GBP). Demand of the currency of UK will start rising which will lead to higher value of GBP. In other words, GBP will start to appreciate, it will become stronger and stronger.

Now, since UK and Japan are open economies that means they trade with each other, then change in interest rate of one economy will definitely impact the other economy. Hence, from British perspective, the demand of GBP will increase and as compared to it, the demand of Yen will fall, due to Japan being less attractive for investments as compared to Britain. Hence, Japanese Yen will depreciate.

To summarise, from teh British perspective, the British currency (GBP) will appreciate and the Jananese currency Yen (¥) will depreciate.