Question

Assume individuals can choose to place their savings in bank accounts in paris (in euros) or in new york (in dollars). what will happen to the exchange rate (euros per dollar) if real interest rates on bank accounts in new york increase? the exchange rate, euros per dollar, will likely:

a. descrease
b. increase
c. no change
d. one cannot tell

Answer 1

An increase in real interest rates on bank accounts in New York will likely lead to an appreciation of the U.S. dollar in terms of the euro, causing the exchange rate (euros per dollar) to increase. So the correct answer is option b.

Step-by-step explanation:

If real interest rates on bank accounts in New York increase, it will make savings in the United States more attractive compared to Paris, assuming all else is equal. As investors seek to capitalize on higher interest rates, demand for dollars will increase to deposit them in New York banks. This surge in demand leads to an appreciation of the U.S. dollar in terms of the euro.

Therefore, one would expect the euro to depreciate relative to the dollar, making the exchange rate (euros per dollar) increase. Using an example, imagine that the initial exchange rate is 0.8 euros per dollar. If real interest rates in New York rise, investors may need to convert their euros to dollars, thus increasing the demand for dollars. As the demand for dollars increases, you would expect the exchange rate to adjust to maybe 0.9 or 1 euro per dollar, depending on the market environment. Hence, the result would be an increase in the euros per dollar rate.

Conversely, if there was a decline in U.S. interest rates compared to the rest of the world, this would likely result in a decrease in the demand for dollars, an increase in the supply of dollars looking to be exchanged for other currencies, and hence a weakening of the dollar against the euro. An increase in the real interest rates on bank accounts in New York would likely cause the exchange rate (euros per dollar) to increase. When interest rates increase, it attracts more foreign investors who want to take advantage of the higher returns. This increased demand for dollars will drive up the value of the dollar relative to the euro, resulting in a higher exchange rate.

Answer 2

An increase in real interest rates in New York bank accounts would likely lead to an appreciation of the U.S. dollar relative to the euro, meaning that the exchange rate (euros per dollar) would increase as it would take more euros to buy one dollar.

Step-by-step explanation:

If real interest rates on bank accounts in New York increase, savers around the world, including those with savings in euros, might switch their savings to New York to take advantage of the higher interest rates. This shift would increase the demand for the dollar as individuals exchange their euros for dollars, leading to an appreciation of the U.S. dollar relative to the euro. Therefore, the exchange rate (euros per dollar) would increase, meaning that it would take more euros to buy one dollar. This can be thought of as an increased 'price' of dollars in terms of euros.

To illustrate further, imagine that the U.S. government increases its borrowing, and the funds come from European investors. To purchase U.S. government bonds, these investors will need more U.S. dollars, causing the demand for dollars to rise. With increased demand and potentially decreased supply of dollars in foreign exchange markets, the exchange rate would strengthen, as seen when the equilibrium exchange rate moves from 0.9 euro/dollar to 1.05 euros/dollar in our example. Thus, in response to an increase in New York's bank account interest rates, the exchange rate of euros per dollar will likely increase.