Suppose that the central bank in the UK (The Bank of England) decides to raise i

Question

Suppose that the central bank in the UK (The Bank of England) decides to raise interest rates because it is worried about high inflation. As a result, interest rates in the UK become higher than interest rates in the REST OF EUROPE. This acts as an incentive for EUROPEAN investors to increase the amount of funds they invest in British (UK) interest bearing assets.

In order to increase their purchases of those UK assets, which are priced in PST, EUROPEAN investors have to convert EUR into PST. This conversion, in turn, increases the demand for PST. Based on the above information, please explain what will happen to the EUR--PST exchange rate. In other words, will the increased demand for PST, make PST gain value (appreciate) or lose value (depreciate) against the EUR? Why?

Explanation / Answer

Due to compete high Inflation, British Government increases interest rates in UK. This creates an opportunity for European Investors to invest in Britain(UK) to earn higher rate of Interest rather than in Europe where there is comparatively lower rate of Interest. So, for investing in UK, European Investors has to convert the EUR into PST. That could have caused an increase in demand for the British pound and the value of the pound to rise.

Demand for Currency

Due to Increase in rate of Interest by British Government, European people tend to invest in British Market. The better deal creates higher demand for English currency.

The demand curve for British pounds in terms of the EUR is a normal downward sloping demand curve. This is because if the value of the British pound went down relative to the EUR, the quantity of pounds demanded by European Investors would increase; when pounds go on sale, more pounds are sold.

Impact of Increased Demand on Currency Conversion

The appreciation of a country's currency refers to an increase in the value of that country's currency. If the British Pounds (PST) appreciates relative to the euro (EUR), the exchange rate falls: it takes fewer British Pounds (PST) to purchase 1 euro (1 EUR=1.5 PST 1 EUR=1.4 PST). When the British Pounds (PST) appreciates relative to the Euro, the Canadian dollar becomes less competitive.

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.