Exchange depreciation rate of one currency in relation to another currency is, approximately, equal to their

A. Inflation rate differential

B. Interest rate differential

C. Growth rate differential

D. Fiscal deficit differential

E. Forex reserve differential

Choose the correct answer from the options given below: 

This question was previously asked in
UGC NET Paper 2: Commerce 4th March 2023 Shift 2
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  1. A, B and C only
  2. C, D and E only
  3. A and B only
  4. D and E only

Answer (Detailed Solution Below)

Option 3 : A and B only
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UGC NET Paper 1: Held on 21st August 2024 Shift 1
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50 Questions 100 Marks 60 Mins

Detailed Solution

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The correct answer is A and B only.

Key Points

  • Inflation rate differential: Higher inflation in a country compared to its trading partners will tend to depreciate its currency. This means that the relative prices of its goods increase, thereby decreasing the demand for its goods and for its currency.
  • Interest rate differential: Countries with higher interest rates often attract more foreign investors as they can get a higher return on their investments. This can lead to an appreciation of the currency. Conversely, if a country has lower interest rates relative to others, its currency is likely to depreciate.
  • Growth rate differential: Strong economic growth attracts foreign investors to invest in a country, thus increasing the demand for its currency, leading to appreciation. While weak or negative growth can lead to outflows of foreign investors, decreasing the demand for the domestic currency, leading to its depreciation.
  • Fiscal deficit differential: Large fiscal deficits can lead to the depreciation of a currency. The rationale is that large fiscal deficits have to be financed by borrowing from overseas, which increases the demand for foreign currency, resulting in relative depreciation of the domestic currency. However, the effect of fiscal deficits on exchange rates isn't as direct or substantial as the effect of inflation and interest rates.
  • Foreign exchange (Forex) reserve differential: Foreign exchange reserves do affect a currency’s value but the relationship is complex and not as direct as with inflation or interest rates. Increases in a country's Forex reserves might indicate that the country's central bank is trying to prevent the currency from appreciating. Conversely, a decrease in reserves might indicate an attempt to prevent the currency from depreciating.
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