Question

Explain why you agree or disagree with the following statements. Assume other things equal.

a. A country that grows faster than its major trading partners can expect the international value of its currency to depreciate.

b. A nation whose interest rate is rising more rapidly than interest rates in other nations can expect the international value of its currency to appreciate.

c. A country's currency will appreciate if its inflation rate is less than that of the rest of the world.

Short answer

Yes, a country growing faster than its major trading partners will face depreciation because the supply of currency rises for the country with a high growth rate making the currency depreciate.

Yes, a nation with a higher and rising interest rate than interest rates in other nations will face appreciation as the demand for currency in the country rises with the rising interest rates.

Yes, a country's currency will appreciate if its inflation rate is less than that of the rest of the world because the demand for the currency of the country with less inflation rises, so the currency appreciates.

Step-by-step solution

Factors affecting appreciation or depreciation of the currency

In general, the reasons that cause a nation's currency to appreciate or depreciate in the FOREX market are the demand and supply of a nation's currency. The currency will appreciate if the demand for a nation's currency increases; conversely, when the supply of a nation's currency increases, that currency depreciates.

A nation's currency appreciates relative to the depreciation of some foreign currency.

Given all the above generalizations, the determinants of exchange rates can be examined: the factors that shift the demand or supply curve for a certain currency, keeping other things constant.

Country experiencing a high growth rate

A country's currency will depreciate if the national income growth is more rapid than other countries. A country's imports vary directly with its income level. As national income rises, the country's imports will rise. The surge in imports will increase the demand for other country's currency in the FOREX market. Thus, due to an increase in the supply of currency (due to a high growth rate), that country's currency will depreciate.

Country with a rising interest rate

A nation's currency appreciates relative to some foreign currency when its interest rates rise.

Any changes in relative interest rates between two countries change their exchange rate. Suppose that real interest rates rise in one country but stay constant in another. The other countries will then find the first country an attractive place to loan money directly (or buy bonds). The demand for a country's currency will rise where the interest rates are high, its currency will appreciate.

Country with less inflation rate

Keeping other things unchanged (constant), changes in the relative inflation rates of two nations change their relative price levels and alter the exchange rate between their currencies. The currency of the nation with the higher inflation rate depreciates.

Suppose inflation is higher in country 1 than in country 2. Consumers of country 1 will seek out more of the now relatively lower-priced other country's goods, increasing the demand of currency of country 2 at the FOREX market. The increase in demand for the currency of country 2 with low inflation will appreciate its currency.