An increase in the domestic one-year interest rate expected to occur in,say,two years will,all else fixed,have which of the following effects in a flexible exchange rate regime?
A)The real exchange rate will increase with no change in the nominal exchange rate.
B)The nominal exchange rate will increase with no change in the real exchange rate.
C)Both the real and nominal exchange rate will increase.
D)No change in either the nominal or real exchange rate.

Question

Quizplus · Accepted Answer

An increase in the domestic one-year interest rate will lead to an increase in the demand for domestic currency, which will cause the nominal exchange rate to increase. This will also lead to an increase in the real exchange rate, as the nominal exchange rate will increase more than the inflation rate.

An Increase in the Domestic One-Year Interest Rate Expected to Occur