The interest rate on government bonds in India rises from 6 per cent to 8 per cent, while equally safe US bonds still pay 7 per cent. There are no limits on buying foreign bonds, and the exchange rate is flexible. What is the likely effect?
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → The supply of dollars rises and the rupee appreciates, so the rupee-dollar exchange rate falls.
Money moves to the country where interest rates are higher. Indian bonds now pay 8 per cent against 7 per cent in the USA, so US investors bring in dollars to buy rupees, and Indians want fewer dollars.
The supply of dollars rises and the demand for dollars falls. Fewer rupees are now needed per dollar: the rupee appreciates and the rupee-dollar rate falls. Under a flexible rate, the RBI does not step in.
NCERT (2026-27): “Interest Rates and the Exchange Rate In the short run, another factor that is important in determining exchange rate movements is the interest rate differential i.e. the difference between interest rates between countries. 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.” “Flexible Exchange Rate This exchange rate is determined by the market forces of demand and supply. It is also known as Floating Exchange Rate. As depicted in Fig. 6.1, the exchange rate is determined where the demand curve intersects with the supply curve, i.e., at point e on the Y – axis. Point q on the x – axis determines the quantity of US Dollars that have been demanded and supplied on e exchange rate. In a completely flexible system, the Central banks do not intervene in the foreign exchange market. …” |