Question

Mention the relationship (changes) between these 3 factors (inflation, interest rates & income levels) and exchange rates (hint: inflation goes up, currency depre…). (6 points)

Answer 1

(1)

When domestic inflation increases (decreases), domestic exportable goods become less (more) competitive in global market. This decreases (increases) exports and increases (decreases) imports. So demand for domestic currency falls (rises), which depreciates (appreciates) domestic currency (exchange rate).

(2)

When domestic interest rate increases (decreases), this increases (decreases) foreign investment in the economy. So demand for domestic currency rises (falls), which appreciates (depreciates) domestic currency (exchange rate).

(3)

When domestic income level increases (decreases), this increases (decreases) imports demand. So demand for domestic currency falls (rises), which depreciates (appreciates) domestic currency (exchange rate).