Question

Starting from the position of equilibrium in the foreign exchange market under a fixed exchange regime, which scenario would cause an increase in the value of the domestic currency?

a) Increase in domestic interest rates
b) Decrease in domestic interest rates
c) Increase in foreign interest rates
d) No change in interest rates

Answer 1

An increase in the value of the domestic currency would occur when there is an increase in domestic interest rates. A higher interest rate relative to other countries leads a nation's currency to appreciate or strengthen.

Step-by-step explanation:

In the foreign exchange market under a fixed exchange regime, an increase in the value of the domestic currency would occur when there is an increase in domestic interest rates (option a). When domestic interest rates rise, it attracts foreign investors to invest in the country, leading to an increased demand for the domestic currency. This increased demand causes the value of the currency to appreciate or strengthen.

The motivation for investment, whether domestic or foreign, is to earn a return. If rates of return in a country look relatively high, then that country will tend to attract funds from abroad. A higher interest rate relative to other countries leads a nation's currency to appreciate or strengthen.