In 1994, the United States was experiencing a fairly strong economic recovery, ahead of other nations. Fears of an overheating economy led to sudden inflationary fears for the next few years.
a. Would you expect U.S. interest rates to rise or drop?
b. Would you expect the dollar to depreciate or appreciate?
c. Would you expect a foreign bond portfolio to be a good investment compared to a U.S. dollar portfolio under this scenario?

Question

Quizplus · Accepted Answer

The Answer is a. Inflationary fears will cause interest rates to rise, even if the real interest rate remains constant. Economic growth could also lead to higher real interest rates.
b. The dollar is likely to depreciate because of higher expected inflation. This could be offset by higher real interest rates, which could attract foreign capital flows.
c. The rise of U.S. interest rates will cause the market price of U.S. bonds to fall. It is, therefore, appropriate to invest in foreign bonds rather than U.S. bonds. The likely depreciation of the dollar makes such an investment even more interesting (the foreign currency in which the bonds are denominated will appreciate against the dollar during the investment period and the investor will make a foreign exchange profit when reselling his bonds).

In 1994, the United States Was Experiencing a Fairly Strong