Question

Recall that an exchange rate is the price of one currency in another. For example, it may take US $1.35 to buy 1 British Pound. Also recall the interest rates affect exchange rates. What do you predict will happen to the foreign exchange rate if interest rates in the United States increase more than in the UK? (In other words, which currency will become stronger?) How would such a change affect US exports to the UK? Would it be less expensive for an American tourist to take a vacation to London after the interest rate change? Be sure to clearly explain and justify your reasoning.

Answer 1

Answer:

Exchange Rate and Interest Rate

1. If interest rates in the United States increase more than in the UK, the exchange rate of the US dollars will increase relative to the UK pounds, thus causing the UK pounds to become stronger than the US dollars.

2. US exports to the UK would become cheaper in UK.

3. It would be more expensive for an American tourist to take a vacation to London after the interest rate change because they would need more money to handle the differences.

Explanation:

Generally, higher interest rates in an economy offer investors some higher returns when compared to other countries. These higher interest rates attract foreign capital and cause the exchange rate to rise.  When this happens, the cost of goods and services in the country with the higher interest and exchange rates.  The opposite becomes the case when the interest and exchange rates are lower relative to other countries.