Question

The diagram below shows how the rate of exchange is determined in a free market.

Show the effect of the following on the exchange rate.

1. The rate of interest of the country increases. 

2. The rate of inflation of the nearby countries.

Answer 1

1. When the rate of interest increases the rate of exchange will increase. This is because an increased rate of interest would attract more depositors into the country, the demand for the currency would increase and the rate of interest also will increase as shown in the diagram below.

2. When the inflation of the nearby countries increases the people around would prefer to buy goods from this country. So the demand for the currency would increase leading to an increase in the rate of exchange.