Final answer:
The U.S. interest rate differential increases if the foreign interest rate falls, and the greater this differential, the higher the demand for U.S. dollars in the foreign exchange market.
Step-by-step explanation:
The U.S. interest rate differential rises if the foreign interest rate falls, and the larger the U.S. interest rate differential, the greater is the demand for U.S. dollars in the foreign exchange market. The correct answer is A: the foreign interest rate falls; greater. When U.S. interest rates are high relative to other countries, foreign capital is attracted to the higher returns available in the U.S., thus increasing the demand for U.S. dollars. Conversely, when Americans find U.S. bonds more attractive due to higher interest rates domestically compared to foreign bonds, they supply fewer U.S. dollars to the foreign exchange market. This change in demand and supply dynamics leads to an appreciation of the U.S. dollar's exchange rate. Inflows of foreign investment capital, interest rates, and exchange rates are interconnected, with budget deficits potentially leading to larger trade deficits due to these economic relationships.