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Question about Floating exchange rate

A country has a lower inflation rate than all other countries, It has more rapid economic growth. The central bank does not intervene in the foreign exchange market. What can you say about each of the following (and why)?:

a. The exchange rate?
b. The current account balance?
c. The expected exchange rate?
d. The interest rate differential?
e. Interst rate parity?
f. Purchasing power equity?

Solution Preview

A country has a lower inflation rate than all other countries. It has more rapid economic growth. The central bank does not intervene in the foreign exchange market. What can you say about each of the following (and why)?:

a. The exchange rate?

Changes in relative inflation between two countries must cause a change in exchange rates. If domestic inflation rate is lower than that in the foreign country, the domestic currency should be stronger than the foreign currency

The country's currency will be strong and appreciate against other countries.

Spot exchange rates between currencies will change to the differential in inflation rates between countries.

b. The current account balance?

Initially, this country would have a current account surplus. However, finally the current account would balance (no surplus or deficit).

Because this country has lower inflation, its prices would be lower and foreigners would like to purchase goods from this country. The citizens of this country would demand less of ...

Solution Summary

The solution describes the exchange rate, the current account balance, the expected exchange rate, the interest rate differential, the interst rate parity and the purchasing power equity in a country which has a lower inflation rate than all other countries, more rapid economic growth and where the central bank does not intervene in the foreign exchange market.

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