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ACCA Applied Knowledge · Business and Technology · Macroeconomic factors

A country's central bank cuts its base rate sharply. Assuming other factors are unchanged, which effect on the country's currency is most likely?

The currency will most likely depreciate. A lower base rate reduces returns on assets in that currency, so foreign investors move funds elsewhere and demand for the currency falls. Appreciation would follow a rate rise, and interest rates clearly do affect exchange rates through capital flows.

  1. AThe currency tends to depreciate as foreign investors seek higher returns elsewhereCorrect
  2. BThe currency tends to appreciate as foreign capital floods in
  3. CThe currency value is unaffected because interest rates only affect domestic saving
  4. DThe currency becomes fixed against all others

Explanation

Lower domestic interest rates reduce the return on assets held in that currency, so capital flows out and demand for the currency falls, causing depreciation. Appreciation would follow a rate rise. Rates do influence exchange rates through capital flows, and a cut does not fix a currency.

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