Question

3. Suppose there are two countries that are otherwise the same (e.g. in regards to inflation and risk etc.) except that Country S3 has a strong economy and Country W3 has a weak economy. Suppose one or both of the central banks of S3 or W3 is pursuing a domestic monetary policy such that interest rates do not equalize between the two countries. Which country will tend to have the weaker currency in foreign exchange markets?

7. Suppose a country wants to fix the exchange rate of its domestic currency lower than what markets alone would bring about. Which would the central bank do, buy the domestic currency or sell the domestic currency?

Answer 1

3. The country W3 tends to have the weaker currency in foreign exchange markets. Since, it is a weak economy, the central bank of country W3 would have to reduce its interest rates to provide monetary stimulus to the economy. Due to this, the capital will flow out of W3, since foreign investors would want to invest in S3 as it is offering higher interest rate. This leads to depreciation in the currency of W3 as capital outflow would increase the supply of its currency vis a vis the currency of S3.