Question

Consider a large country such as the United Kingdom. Because the investors have a negative view of the economy, an outflow of pound sterling occurs. A significant sum of Pound Sterling is converted to US dollars in order to purchase US Treasury bonds. Based on our model, what is the expected effect on the UK real interest rate? Group of answer choices

a. the UK real interest rate rise
b. the UK real interest rate falls
c. the UK interest rate does not change
d. the effect on the UK real interest rate may rise or fall.

Answer 1

When a country's currency is expected to appreciate, it can lead to a decrease in the country's interest rates.

Step-by-step explanation:

When a country's currency is expected to appreciate in value, it means that the currency is expected to strengthen against other currencies. In this case, the international investor expects the British pound (£) to buy $1.60 in U.S. currency instead of its current exchange rate of $1.50.

As a result of the expected appreciation, the investor may convert a significant sum of Pound Sterling to US dollars to purchase US Treasury bonds. This increase in demand for US Treasury bonds can lead to a decrease in their yields, which is essentially the interest rate paid on the bonds. Therefore, the expected effect on the UK real interest rate is that it falls.

Overall, when a country's currency is expected to appreciate, it can lead to a decrease in the country's interest rates due to increased demand for foreign assets.