Question

In a developing country, would an increase in the interest rate always be followed with an appreciation of the country’s currency? Explain your answer.

5 marks!

Answer 1

Increasing the interest rate is a medium for controlling the cash flow in the economy. The government often in collaboration with the central bank of a country controls the money flow in the economy.

When a developing country's interest rate is increased the money flow in the economy is reduced as it reduces the disposable income in the hands of the individuals. This helps in controlling the inflation of the company. To the higher interest rates, the individuals saving the money in Bank account for higher interest returns.

The overall consumption at domestic level drops as compared to the international level, creating more export and thus more demand for the currency eventually leads to an appreciation of the country's currency also.