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Explain why an increase in U.S. interest rates relative to UK interest rates would affect the U.S.-UK exchange rate.

Answer :

An increase in U.S. interest rates relative to UK interest rates can lead to an appreciation of the U.S. dollar and a depreciation of the UK pound. The movement in exchange rates can have implications for investment flows, trade balances, and inflation levels between the two countries.

An increase in U.S. interest rates relative to UK interest rates would affect the U.S.-UK exchange rate due to the following reasons:

1. Attracting Foreign Capital: When U.S. interest rates increase, it becomes more attractive for foreign investors to invest in U.S. financial assets such as bonds and stocks. The higher interest rates provide a higher return on investment. As a result, the demand for U.S. dollars increases, leading to an appreciation in the value of the U.S. dollar.

2. Capital Outflow: Conversely, when U.S. interest rates increase relative to UK interest rates, it can lead to capital outflow from the UK to the U.S. Investors seek higher returns, and if interest rates in the U.S. are higher, they may choose to move their capital from the UK to the U.S. This capital outflow from the UK increases the supply of UK pounds in the foreign exchange market, which puts downward pressure on the value of the pound, causing it to depreciate.

3. Trade Balance: Changes in exchange rates can also impact the trade balance between countries. A stronger U.S. dollar resulting from higher U.S. interest rates makes U.S. exports more expensive for UK buyers. At the same time, UK exports become relatively cheaper for U.S. buyers. As a result, U.S. exports may decrease, and UK exports may increase, leading to a trade imbalance.

4. Inflation: Higher U.S. interest rates can also affect inflation levels in both countries. When U.S. interest rates increase, it can potentially reduce inflationary pressures in the U.S. On the other hand, if UK interest rates remain unchanged, it may result in relatively higher inflation in the UK. This difference in inflation rates can affect the purchasing power of each currency, impacting the exchange rate.

To know more about foreign exchange market refer to

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