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Consider a scenario where the Bank of England views the UK economy to be overheating and is attempting to slow the economy down using monetary policy. Which of the following statements regarding the effects of an interest rate rise via the exchange rate channel is correct?

a. It leads to higher bond prices, which results in higher demand for UK bonds.
b. It leads to higher demand for GBP, which results in a depreciation of the GBP.
c. It leads to UK imports being cheaper and exports more expensive, which depresses aggregate demand in the UK.
d. Lower interest rates attract international investors, which in turn raises demand for GBP.

Answer :

In this scenario, the Bank of England is using monetary policy to address an overheating economy in the UK. One of the primary tools of monetary policy is the manipulation of interest rates. Here's how an interest rate rise can affect the economy through the exchange rate channel:

When the Bank of England increases interest rates, several things typically happen:

  1. Higher Interest Rates and International Investment: Higher interest rates make financial assets in the UK, such as bonds, more attractive to investors because they offer better returns compared to lower-yielding assets elsewhere. This leads to higher demand for UK assets.

  2. Increased Demand for the British Pound (GBP): As foreign investors seek to purchase UK assets, they need to exchange their currencies for the British Pound (GBP). This increased demand for GBP results in an appreciation of the GBP.

  3. Effects on Imports and Exports: An appreciated GBP makes UK exports more expensive for foreign buyers, while imports become cheaper for UK consumers. This shift tends to depress aggregate demand domestically, as more money is spent on imports rather than domestic goods, and it becomes harder to sell goods abroad due to higher prices.

Now, examining the multiple-choice options:

  • Option a: Incorrect. While higher interest rates can attract investment due to potentially higher returns, it doesn't inherently lead to higher bond prices; usually, bond prices fall when interest rates rise.

  • Option b: Incorrect. Higher demand for GBP usually results in appreciation, not depreciation.

  • Option c: Correct. This option accurately describes the effect of higher interest rates leading to appreciation, making UK imports cheaper and exports more expensive, thereby depressing aggregate demand.

  • Option d: Incorrect. Higher interest rates, not lower, attract international investors, increasing demand for GBP.

Therefore, the correct statement is option c.

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