Explain behavior of the nominal exchange rate

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Reference no: EM133289274

Assignment:

Nominal Exchange Rate Movement

Suppose that the central bank in the UK (The Bank of England) decides to raise interest rates because it is worried about high inflation. As a result, interest rates in the UK become higher than interest rates in the REST OF EUROPE. This acts as an incentive for EUROPEAN investors to increase the amount of funds they invest in British (UK) interest bearing assets. In order to increase their purchases of those UK assets, which are priced in PST, EUROPEAN investors have to convert EUR into PST. This conversion, in turn, increases the demand for PST. Based on the above information, please explain:

1. Given that interest rates in the UK are now different than that in Europe, what equation/condition may be used to explain this behavior of the (nominal) exchange rate. (Note: you just need to state the name of the equation or condition that may be used).

2. What will happen to the EUR----PST exchange rate. In other words, will the increased demand for PST, make PST gain value (appreciate) or lose value (depreciate) against the EUR? (Please indicate your answer by picking one of the following: Appreciate/Depreciate/Stay the same.

3. Why? Please give a brief explanation using the equation or condition that you chose to illustrate why the exchange rate will move the way that you indicated.

Reference no: EM133289274

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