In a situation of flexible exchange rates, an exogenous increase in foreign interest rates will cause __________ of the domestic currency and, most likely, a __________ in the domestic interest rate.

Question

Quizplus · Accepted Answer

An exogenous increase in foreign interest rates makes foreign financial assets more attractive, leading to capital outflows from the domestic economy. This increases the supply of the domestic currency in the foreign exchange market, causing its depreciation. To counteract capital outflows and stabilize the currency, the domestic central bank may increase interest rates, hence a rise in the domestic interest rate.

In a Situation of Flexible Exchange Rates, an Exogenous Increase