Question

1. Suppose there are two countries that are otherwise the same (e.g. in regards to inflation and risk etc.) except that they have different interest rates. Country L1 has low interest rates and Country H1 has high interest rates.

(a) For Country H1, which will happen in foreign exchange markets, an increase in demand for the country’s currency or an increase in supply of the country’s currency?

(b) What happens to the strength of Country H1’s currency?

(c) What happens to the supply of financial capital in Country H1?

(d) What happens to the interest rate in Country H1?

2. Suppose there are two countries that are otherwise the same (e.g. in regards to inflation and risk etc.) except that Country L2 is a lending country and Country B2 is a borrowing country.

(a) For Country L2, which will happen in foreign exchange markets, an increase in demand for the country’s currency or an increase in supply of the country’s currency?

(b) What happens to the strength of Country L2’s currency?

(c) What happens to the trade balance for Country L2?

Answer 1

1. Suppose there are two countries that are otherwise the same (e.g. in regards to inflation and risk etc.) except that they have different interest rates. Country L1 has low interest rates and Country H1 has high interest rates.

(a) For Country H1, which will happen in foreign exchange markets, an increase in demand for the country’s currency or an increase in supply of the country’s currency?

Answer: For country H1, the demand for its currency will increase as people will like to invest more in it expecting higher returns.

(b) What happens to the strength of Country H1’s currency?

Answer: The currency strength will increase as demand for its currency increases as it offers higher interest rates.

(c) What happens to the supply of financial capital in Country H1?

Answer: The supply of financial capital will increase expecting higher returns on money given as loan.

(d) What happens to the interest rate in Country H1?

Answer: The interest rates are higher and due to more inflow of money. The supply of money may be more than its demand and interest rates may go down to create more demand.