Equally safe government bonds pay a higher rate of interest in country B than in country A, and there are no restrictions on buying foreign bonds. Arrange the following in the order in which they follow:
(A) Country A’s currency depreciates.
(B) Investors from country A buy country B’s currency, selling their own.
(C) The demand curve for country A’s currency shifts left and its supply curve shifts right.
(D) Investors in country A are attracted by the higher interest rate in country B.
Choose the correct answer from the options given below:
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → (D), (B), (C), (A)
Large funds move around the world in search of the highest interest rate. The difference in interest rates, the interest rate differential, sets off a chain in the foreign exchange market.
(D) Investors in country A are attracted by the higher interest rate in country B. — The higher return in B is what starts the chain.
(B) Investors from country A buy country B’s currency, selling their own. — They need B’s currency to buy B’s bonds.
(C) The demand curve for country A’s currency shifts left and its supply curve shifts right. — Investors in B also want less of A’s currency, while A’s investors sell their own currency.
(A) Country A’s currency depreciates. — Less demand and more supply lower the price of A’s currency.
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.” |