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ACCA Applied Skills · Financial Management · The economic environment for business

Which of the following is most likely to cause a country's currency to depreciate in the foreign exchange market, other things being equal?

Persistently higher domestic inflation than trading partners is most likely to cause depreciation. Under purchasing power parity the currency must fall to offset the loss of price competitiveness, whereas higher interest rates, trade surpluses and inward investment all raise demand for the currency.

  1. AA rise in domestic interest rates relative to those abroad
  2. BA sustained current account surplus
  3. CDomestic inflation persistently higher than that of trading partnersCorrect
  4. DIncreased foreign direct investment into the country

Explanation

Higher relative inflation erodes competitiveness and, under purchasing power parity, leads to depreciation. Higher interest rates, a surplus and inward investment all increase demand for the currency and tend to cause appreciation.

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