CFA Level I · CFA Level I Exam · Capital Flows and the FX Market
A country's central bank unexpectedly raises its policy rate while inflation expectations stay unchanged. Holding other factors constant, the domestic currency is most likely to:
The domestic currency will most likely appreciate. With inflation expectations unchanged, a higher policy rate lifts real returns on domestic assets, attracting foreign capital inflows that raise demand for the currency. This is the standard short-run effect of real interest rate differentials on exchange rates.
- Adepreciate because of lower real returns
- Bappreciate because of higher expected real returns attracting capital inflowsCorrect
- Cremain unchanged because only the nominal rate has moved
Explanation
With unchanged inflation expectations, a higher nominal rate raises the real interest rate. This attracts foreign portfolio capital, increasing demand for the domestic currency and causing appreciation in the short run. Real returns rise, not fall, so depreciation is wrong.
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