Final answer:
Financial transactions are sensitive to anticipated exchange rate changes but generally insensitive to relative interest rate changes. If a currency is expected to appreciate, yields on investments like government bonds may be lower due to the expected return from currency appreciation, while central banks watch exchange rates to guide their monetary policy.
Step-by-step explanation:
The transactions in currency, bank deposits, and similar financial instruments tend to be sensitive to anticipated changes in exchange rates but are generally insensitive to changes in relative interest rates. When a country's currency is expected to appreciate, international investors are more likely to invest in that country's assets, such as government bonds, which drives up the demand for the currency leading to an appreciation. Given this expectation, the yield on those assets, like the interest rate on government bonds, may not have to be as high to attract investors, since the gains from the currency appreciation are expected to provide part of the return on their investment.
Furthermore, a central bank monitors exchange rates closely as they have a significant impact on the economy. Movements in the exchange rate can affect aggregate demand and disrupt international trade, while substantial fluctuation can lead to an unsustainable balance of trade and raise the risk of a deep recession if international investors move their capital elsewhere. These considerations influence the central bank's monetary policy, which in turn affects interest rates and yields on government bonds.