Under a flexible exchange rate system, interest rates in India rise while those abroad stay the same. There are no restrictions on buying Indian bonds, and other things remain the same.
How many of the following statements are correct?
(A) Foreign investors demand more rupees to buy Indian bonds.
(B) The supply of dollars in India’s foreign exchange market rises.
(C) Indian investors buy more foreign bonds.
(D) The rupee appreciates against the dollar.
(E) The supply of dollars falls as foreign investors pull money out of India.
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Only three
Funds move around the world in search of the highest interest rates. When Indian rates rise, foreign investors buy Indian bonds, so dollars flow in and the rupee gains value.
(A) Foreign investors demand more rupees to buy Indian bonds. — Correct. Indian bonds now pay more, and they are bought with rupees.
(B) The supply of dollars in India’s foreign exchange market rises. — Correct. Foreigners bring dollars in to buy Indian assets.
(C) Indian investors buy more foreign bonds. — Incorrect. Home bonds have become more attractive, so Indians buy fewer foreign bonds.
(D) The rupee appreciates against the dollar. — Correct. A rise in home interest rates often leads to an appreciation of the home currency.
(E) The supply of dollars falls as foreign investors pull money out of India. — Incorrect. Foreign investors move money into India, so the supply of dollars rises.
Statements (A), (B) and (D) are correct.
NCERT (2026-27): “Interest Rates and the Exchange Rate … There are huge funds owned by banks, multinational corporations and wealthy individuals which move around the world in search of the highest interest rates. If we assume that government bonds in country A pay 8 per cent rate of interest whereas equally safe bonds in county B yield 10 per cent, the interest rate differential is 2 per cent. Investors from country A will be attracted by the high interest rates in country B and will buy the currency of country B selling their own currency. At the same time investors in country B will also find investing in their own country more attractive and will therefore demand less of country A’s currency. This means that the demand curve for country A’s currency will shift to the left and the supply curve will shift to the right causing a depreciation of country A’s currency and an appreciation of country B’s currency. Thus, a rise in the interest rates at home often leads to an appreciation of the domestic currency. Here, the implicit assumption is that no restrictions exist in buying bonds issued by foreign governments.” “Supply of Foreign Exchange Foreign currency flows into the home country due to the following reasons: exports by a country lead to the purchase of its domestic goods and services by the foreigners; foreigners send gifts or make transfers; and, the assets of a home country are bought by the foreigners. …” |