Question

(b) Suppose in year 1, the nominal exchange rate for the currencies of Countries A and B was 1.00 to 1.00. Aside from the data below, the countries are the same.

	Country A	Country B
Real GDP, year 1	100	100
Real GDP, year 15	170	140

For year 15, which currency will be stronger? Why?

Answer 1

Country B will have a stronger currency in year 15. GDP growth and exchange rates are correlated. An increase in GDP implies an increase in income of people and hence economic activities increase in the country. As a result of increased economic activity (including increase in imports) and demand for money, the central bank would increase the rate of interest. This would result in capital inflow from around the world, strengthening the economy even further.

This is why the country with a higher GDP growth would have a stronger currency, in this case Country B.