According to the long-run (i.e., monetary) approach to exchange rate, an exogenous increase in domestic interest...

According to the long-run (i.e., monetary) approach to exchange rate, an exogenous increase in domestic interest rate (increases/decreases) real money demand, and thereby the price level (increases/decreases). As a consequence, domestic currency (depreciates/appreciates).

Expert Solution

Answer

According to the long-run (i.e., monetary) approach to exchange rate, an exogenous increase in domestic interest rate increases real money demand, and thereby the price level increases. As a consequence, domestic currency appreciates.

Reason:

Let us understand this with an example-

Suppose there are two countries UK and Japan that trade with each other.

In case the real interest rate in UK (domestic country) 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. Also, at the same time with more and more money in the hands of the people, the consumption levels in UK will increase, thus, raising the price level.

Rahul Sunny answered 2 years ago

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