Answer to Question #227266 in Macroeconomics for Bongiwe

Question

According to the interest-parity relation ...
1. a higher domestic interest rate leads to a depreciation of the nominal exchange rate.
2. a higher domestic interest rate leads to an appreciation of the nominal exchange rate.
3. the domestic interest rate has no impact on the nominal exchange rate.
4. a depreciation of the nominal exchange rate leads to a lower domestic interest rate.
5. an appreciation of the nominal exchange rate leads to a higher domestic interest rate.

Answer 1

According to interest parity concepts difference in interest rates are reflected by difference in exchange rate between two countries.

option 2 is correct 

a higher domestic interest rate leads to an appreciation of the nominal exchange rate.

Explanation 

A high interest rate attract more foreign capital so increase in investment from other countries increase the demand for local currencies and hence local currency appreciate as compared to other countries currencies.

But decrease in interest rates will decrease the foreign capital and hence there will be outflow of foreign currencies and hence demand for domestic currency will decrease and hence domestic currency depreciate against other currencies.