Question

Suppose the domestic and foreign interest rates are both initially equal. Now suppose the domestic interest rate rises. Explain what effect this will have on the exchange rate, net exports and consequently on output. Also, explain what must occur for the interest parity condition to be restored.

Answer #1

An increase in the interest rate in the local economy will attract more and more funds from the international market that will increase the demand for the local currency and cause an appreciation in the rate. This will reduce the exports and the exports are now costlier, increase the imports, and reduce the net exports, this will lead to a shift in the demand curve to the left and the output will decrease.

this inflow of the funds will continue to the point were the interest rate in the other nations increase to the point to the local nation and due to increased input of funds the interest rate in the local nation will fall. till the interest rate are equal in both the nations.

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Foreign currency is expected to depreciate by 2%
Foreign interest rates are expected to increase by 2%
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