Final answer:
The demand for Brazilian bonds increases and the Brazilian real appreciates relative to the U.S. dollar when the U.S. lowers interest rates to 2%, while the Brazilian interest rate remains at 8%. Option C is correct.
Step-by-step explanation:
When the Federal Reserve lowers U.S. interest rates to 2% from 8%, the return on U.S. bonds becomes less attractive compared to Brazilian bonds, which remain at an 8% interest rate. This causes investors to shift their demand from U.S. bonds to Brazilian bonds in search of higher returns.
Therefore, the demand for Brazilian bonds would increase relative to the demand for U.S. bonds. Consequently, with increased demand, the Brazilian real would likely appreciate relative to the U.S. dollar as more investors need to convert their dollars to reals to purchase the Brazilian bonds. Hence, the correct answer to the student's question is (C) increase; appreciate.
When US interest rates decline compared to the rest of the world, we can expect the demand for dollars to decrease. This is because lower interest rates make US assets less desirable compared to assets in other countries. As a result, there will be an increase in the supply of dollars in foreign currency markets, which will lead to the depreciation of the US dollar in relation to other currencies, such as the euro.