Suppose a reduction in the domestic one-year interest rate expected to occur in

Question

Suppose a reduction in the domestic one-year interest rate expected to occur in two years . All else fixed, will the reduction in interest rate have which of the following effects in a flexible exchange rate regime?

a. the real exchange rate will decrease with no change in the nominal exchange rate.

b. the nominal exchange rate will decrease with no change in the real exchange rate.

c. no change in either the nominal or real exchange rate.

d. both the real and nominal exchange rate will decrease.

Explanation / Answer

(b) is the answer . because reduction in interest rate on domestic bond will reduce the demand for domestic bond. capital inflow will fall depreciate domestic currency in nominal terms . this will increase aggregate demand in goods market resulting in increase in general prices resulting in overall inflation so real exchange rate will remain unaffected.

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