Question

Assume a system of floating exchange rates and high capital mobility. In response to relatively high interest rates abroad, suppose domestic investors place their funds in foreign capital markets. Other things equal, the result would be

a. a depreciation of the domestic currency and a fall in net exports.
b. a depreciation of the domestic currency and a rise in net exports.
c. an appreciation of the domestic currency and a fall in net exports
d. an appreciation of the domestic currency and a rise in net exports.

Answer 1

The placement of funds in foreign capital markets due to higher interest rates abroad results in the depreciation of the domestic currency and a subsequent rise in net exports.

Step-by-step explanation:

b. a depreciation of the domestic currency and a rise in net exports.

When domestic investors invest in foreign capital markets due to higher interest rates abroad, they must convert their domestic currency into foreign currency. This increases the supply of the domestic currency in the foreign exchange market and reduces its demand as fewer domestic assets are being purchased by these investors. The result of this action is a depreciation of the domestic currency.

As the domestic currency depreciates, domestic goods and services become relatively cheaper for foreigners. This should increase the demand for domestic exports, thus leading to a rise in net exports. On the flip side, the higher interest rates abroad can also attract foreign investment into these markets, which can lead to an appreciation of their currency and influence the balance of trade. However, in this scenario, the focus is on domestic investor behavior and its immediate impact on the domestic currency and net exports, without delving into the effects of potential foreign investment responses.