Only provide your opinions when specifically called for. In all other cases your
ID: 2444098 • Letter: O
Question
Only provide your opinions when specifically called for. In all other cases your answer(s) should rely on the text and module materials and not on the internet, showing your capacity to apply the appropriate economic principles and concepts correctly.
1. Assume that the Central Bank of Nation X is responsible for maintaining fixed exchange rates by buying and selling domestic and foreign currencies in exchange markets. Now suppose that interest rates in Nation X are rising in relation to interest rates in other nations. How does the Central Bank of Nation X respond in order to keep the value of its currency stable? Explain.
2. How are exchange rates determined if that currency is allowed to float?
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Explanation / Answer
a) When the interest rate of nation X rises in comparison to other nations, the economy will see an inflow of investment funds from the other economy. Due to inflow, the local currency will appreciate i.e. the demand for the local currency will be higher which will increase the exchange rate of the local currency when compared to other nations.
The central bank of the nation will have to purchase the foreign currency form the market to increase the supply of the local currency and decrease the supply of foreign currency from the market.
b) If the currency is allowed to float then the demand and supply of currency determines the exchange rate. For example, if the demand for the currency is high the exchange rate for that currency i.e. the value of that currency as compared to other currency will rise, if the demand is low the exchange rate will fall. Similarly, if the supply of currency is high then the exchange rate will fall and vice Versa.
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