Question

Use the graph of the exchange rate and the rate of return on domestic and foreign assets to assess the impact of

i. Changes in the domestic real interest rate ( 10 marks)

ii. Changes in domestic expected inflation on exchange rate fluctuate in the short run. ( 10 marks)

Answer 1

The domestic rate of return is not dependent on the exchange rate and hence it is represeneted as a straight line in the diagram, The foreign asset rate of return is dependent on th exchange rate and this is represented as a downward slopping line in the diagram. This is because the domestic rate of return is inversely proportional to the exchange rate. When the rate of return is high, there is inflow of capital in the country, which is then left to mature. On maturity, when the investors get their money back, the market is flooded with excess supply of the foreign currency which causes its value to depreciate, hence proving the negative relationship.

i) When the domestic rate of return changes as a result of some internal monetary policy irrespective of the exchange rate, the vertical line will shift. It can shift outwards or inwards, as is the situation. In this case, let us assume that the domestic rate of return line shifts outwards, that is there is an increase in the interest rate due to tight domestic monetary policy. As can be seen from the diagram, this means a higher interest rate which means more foreign investors will invest in the domestic economy. As a result of this, there will be inflow of capital in the country and the demand for domestic currency which the investors will need to be able to invest in the economy will increase. This will cause an appreciation in the domestic currency, as is shown in the diagram.

ii) A change in the inflation rate will also affect the interest rates, in real terms. Inflation causes the real interest rates to fall. Hence, if the investors anticipate an increase in the domestic inflation rates, then the rate of interest line will shift to the left. As a result, there will be an outflow of capital from the economy, which will increase the amount of domestic currency in circulation in the market.The investors will now increase their investment in the foreign economy, and since this increase is brought about by no change in the interest rate or exchange rate of the foreign economy, this will shift the foreign interest curve outwards. This shows that there will be a resultant depreciation of the domestic currency, or an appreciation of the foreign currency, as can be seen in the diagram.