Question

If the real interest rate on U.S. bonds increases, all else constant, we can expect to...

If the real interest rate on U.S. bonds increases, all else constant, we can expect to see?

A. increase in supply of dollars in foreign markets, leading to depreciation of the US dollar

B. increase in supply of dollars in foreign markets, leading to appreciation of the US dollar

C. an increase in the demand for dollars in the foreign exchange markets, leading to a depreciation of the US dollar

D. an increase in the demand for dollars in foreign exchange markets, leading to a appreciation of the US dollar

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Answer #1

When there is an increase in the real interest rate on U.S bonds, they will become a more attractive investment for the rest of the world because of higher returns. Foreign investors would like to buy more bonds and to purchase bonds they will need more dollars. This will increase the demand for U.S. dollars in the market. As demand for U.S. dollars becomes more than supply, this will cause an appreciation of U.S. dollars because now people have to pay more in their own currency to get one extra dollar.

Hence, the correct answer is Option D i.e. If the real interest rate on U.S. bonds increases, all else constant there will be an increase in the demand for dollars in foreign exchange markets, leading to an appreciation of the U.S. dollar.

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