Question

In general, several variables appear to affect the future value of a currency. Everything else being equal, with reference to the home country, clearly explain in a couple of sentences how each of the following variables are likely to appreciate or depreciate the country’s currency.

a. Increase in GDP/output

b. Increase in real interest rate (Ir)

c.Increase in inflation

d. Increase in money supply (M)

e. Increase in nominal interest rate (In)

f. Increase in current account surplus

Answer 1

a. Increase in GDP/output: This is likely to increase the demand for imported goods as income of consumers is increased. We thus need more foreign currency so domestic currency is depreciated when it is supplied in exchange for foreign one.

b. Increase in real interest rate (Ir): This brings in capital inflows. Net capital outflow decreases and this increases the demand for domestic currency. Thus, it appreciates.

c.Increase in inflation: This would make domestic goods relatively expensive and so demand for exports declines. Hence, currency demand decreases and currency depreciated.

d. Increase in money supply (M): This is likely to increase the demand for imported goods as increased money supply increases income of consumers is increased. We thus need more foreign currency so domestic currency is depreciated when it is supplied in exchange for foreign one.

e. Increase in nominal interest rate (In): This brings in capital inflows. Net capital outflow decreases and this increases the demand for domestic currency. Thus, it appreciates.

f. Increase in current account surplus: This implies savings exceeds investment so there is an increase in net exports because of currency depreciation.