When the domestic nominal interest rate rises because of an increase in expected inflation, the expected appreciation of the dollar declines, ________ shifts out more than ________, and the exchange rate declines.

Question

Quizplus · Accepted Answer

When the domestic nominal interest rate rises due to an increase in expected inflation, the expected return on domestic assets (RS) increases, leading to an appreciation of the domestic currency (U1). However, the increase in expected inflation (P1) reduces the expected real return on domestic assets, which leads to a decrease in demand for domestic assets and a lower exchange rate. Therefore, the supply of foreign assets (FS) shifts out more than the demand for foreign assets (DS), and the exchange rate declines. This is reflected in option A as the correct choice, where the shifts in supply and demand are both accounted for.

When the Domestic Nominal Interest Rate Rises Because of an Increase