Balance of Payments and Exchange Rates: Question 5

Worked solution

Step 1: Recall what drives a floating exchange rate

Under a freely floating system, the exchange rate is determined purely by the demand for and supply of the currency in the foreign exchange market. All else equal, an increase in demand for the currency (or a fall in its supply) causes it to appreciate; a fall in demand (or a rise in supply) causes it to depreciate.

Step 2: Check option C

A rise in global demand for the country’s main export means foreign buyers purchase a greater volume of that export, so they need to acquire more of the country’s currency to pay the exporters. This raises demand for the currency in the foreign exchange market, pushing its equilibrium price up, an appreciation.

Step 3: Rule out options A, B and D

• Option A: higher relative inflation makes the country’s goods more expensive compared with foreign goods, reducing foreign demand for its exports and encouraging its own residents to buy relatively cheaper imports instead, both effects reduce demand for the currency (or raise its supply), tending to cause depreciation.
• Option B: a cut in domestic interest rates makes holding the currency less attractive to foreign investors seeking a return on savings, reducing demand for the currency (and potentially encouraging domestic residents to move funds abroad in search of higher returns), tending to cause depreciation.
• Option D: a rise in residents’ demand for imports means more of the domestic currency is sold (supplied) on the foreign exchange market in order to buy the foreign currency needed to pay for those imports, increasing the supply of the currency and tending to cause depreciation.

Final answer

Option C, a rise in foreign demand for the country’s exports raises demand for its currency in the foreign exchange market, causing an appreciation; A, B and D would all tend to cause a depreciation instead.