Balance of Payments and Exchange Rates: Question 8
Syllabus 6.4
Wexford operates a freely floating exchange rate for its currency, the wex. Wexford's central bank unexpectedly raises its main policy interest rate from 2.5% to 5.5%, while interest rates in Wexford's major trading partners remain unchanged.
(a) Explain, using demand and supply analysis of the foreign exchange market, how this rise in Wexford's interest rate relative to its trading partners is likely to affect the exchange rate of the wex. [4]
(b) State whether the wex has appreciated or depreciated as a result of this interest rate change. [1]
(c) Explain one likely consequence of this change in the exchange rate for Wexford's exporters. [3]
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Worked solution
Part (a): Effect of the interest rate rise on the exchange rate
Wexford’s interest rate rise, with trading partners’ rates unchanged, widens the gap in favour of Wexford. Holding funds in wex-denominated deposits or bonds now offers a higher return than holding equivalent assets abroad, so foreign investors want to move funds into Wexford to take advantage of this. To do this, they must first acquire wex, so this rise in capital inflows shifts the demand curve for the wex to the right on the foreign exchange market.
At the same time, the higher domestic return makes it less attractive for Wexford’s own residents to move their savings abroad in search of a better return, which can also reduce the supply of wex being sold to buy foreign currency. With demand for the wex higher (and supply, if anything, lower), the new equilibrium exchange rate, the price of the wex, is higher than before.
Part (b): Appreciation or depreciation?
Since the equilibrium price of the wex has risen, the wex has appreciated.
Part (c): Consequence for Wexford’s exporters
Because the wex has appreciated, a good priced in wex now costs foreign buyers more of their own currency to purchase than before the interest rate change, even though its wex price is unchanged. This makes Wexford’s exports less price-competitive abroad. If Wexford’s foreign customers respond to this by buying less, or by switching to competitors whose prices have not risen in the same way, Wexford’s exporters are likely to see lower export volumes and revenue. An effect that will be felt most strongly by exporters who compete closely with foreign firms on price.
Final answers
- (a) Higher relative interest rates attract capital inflows seeking a better return, raising demand for (and reducing the supply of) the wex, which raises its equilibrium price
- (b) The wex has appreciated
- (c) Wexford’s exports become more expensive abroad and less price-competitive, likely reducing export volumes and revenue if foreign buyers respond