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A recent shift in the interest rate differential between the United States and Country A had...

A recent shift in the interest rate differential between the United States and Country A had a large effect on the value of Currency A. However, the same shift in the interest rate differential between the United States and Country B had no effect on the value of Currency B. Explain why the effects may vary towards an optimal risky portfolio.

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Answer #1

An exchange rate is impacted due to one or many or all of the factors below:

  • Inflation rate and inflation rate differential
  • Interest rate differential
  • Income Effects i.e. income level differential in the two economies
  • Effect of any trade restrictions
  • Speculative factors
  • Trade deficits
  • Balance of payments

And the list continues.

It will therefore be not possible to see why interest rate differentials can / can't lead to impact on exchange rate between the economies. Interest rate differential can lead to high impact on the exchange rate in case of one economy but no effect on the other.

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