Question

Suppose Corinthia is a major trading partner of Vanadia and there is a sudden decrease in the real interest rate in Vanadia. This will cause:

A. the currency of Vanadia to depreciate.

B. the gross domestic product of Vanadia to decrease.

C. the net exports of Vanadia to decrease.

D. the currency of Vanadia to appreciate.

Answer 1

A sudden decrease in real interest rate in Vanadia would have the following effects:

When the interest rates are high, the currency is considered more valuable. This would attract the investors to invest and the value of currency would increase because the demand of currency increases.

This would imply that the currency is expensive and hence there would be a reduction in exports because less good would be bought with the same amount of currency. So GDP would reduce.

Similarly the case is when the interest rates reduce. When interest rate reduces, the investors would find it unattractive and the value or demand of currency reduces. In such a case the currency depreciates. When the currency depreciates, the exports increase and hence GDP rises.

So GDP would rise, the exports would increase and the currency of Vanadia would depreciate.

Hence answer would be option A) the currency of Vanadia would depreciate.