There are two statements marked as Assertion (A) and Reason (R). Mark your answer as per the options given below.

Assertion: Difference between interest rates between countries is an important factor in determining exchange rate movements in the short run.
Reasoning: In general, other things remaining equal, a country whose aggregate demand grows faster than the rest of the world’s normally finds its currency appreciating.

Assertion (A) is true but Reasoning (R) is not correct.

The correct answer is option 3: Assertion (A) is true but Reasoning (R) is not correct.

Assertion: Difference between interest rates between countries is an important factor in determining exchange rate movements in the short run. This is correct. 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.

Reasoning: In general, other things remaining equal, a country whose aggregate demand grows faster than the rest of the world’s normally finds its currency appreciating. This is incorrect. In general, other things remaining equal, a country whose aggregate demand grows faster than the rest of the world’s normally finds its currency depreciating (not appreciating) because its imports grow faster than its exports. Its demand curve for foreign currency shifts faster than its supply curve.