Question

If a country’s currency is expected to appreciate in value, what would you think will be the impact of expected exchange rates on yields (e.g., the interest rate

paid on government bonds) in that country? Hint: Think about how expected exchange rate changes and interest rates affect a currency's demand and supply.

Short answer

When a country's currency's value rises, demand for it grows as foreign investors convert their currency into another, and supply falls.

Step-by-step solution

Step 1. Define exchange rates.

The rate at which the currencies of two nations can be traded in the market for foreign exchange is known as the exchange rate.

Step 2. Impact of expected exchange rates on yields in that country.

When a country's currency's value rises, demand for it grows as foreign investors convert their currency into another, and supply falls. As a result, the currency exchange rate rises. Because there is a greater demand for money and a higher level of investment, the interest rate on bonds decreases. Because of the low interest rate, holding money has a low opportunity cost.