Very often governments seek to alter the market's valuation of their currency by influencing relative interest rates,

Question

thus influencing the economic fundamentals of exchange rate determination rather than through direct intervention in the foreign exchange markets. Describe how this strategy works. Describe the case of the U.S. or China where the opposite effect, to the suggest here, have occurred.
What will be an ideal response?

Answer 1

Answer: A country may choose to raise domestic interest rates to attract additional capital from abroad (the short-term portfolio component of these capital flows). This step will alter market forces and create additional market demand for the domestic currency in order to restore an imbalance caused by the deficit in the current account. The process also raises the cost of local borrowing for businesses so the policy is seldom without domestic negative consequences. Relatively low real interest rates should normally stimulate an outflow of capital seeking higher interest rates in other country currencies. However, in the case of the United States, the opposite effect has occurred. Despite relatively low real interest rates and large BOP deficits on the current account, the U.S. BOP financial account has experienced offsetting financial inflows due to relatively attractive U.S. growth rate prospects, high levels of productive innovation, and perceived political safety. Thus, the financial account inflows have helped the United States to maintain its lower interest rates and to finance its exceptionally large fiscal deficit. However, it is beginning to appear that the favorable inflow on the financial account is diminishing while the U.S. balance on the current account is worsening.