In the following problem, assume that the UK currency is the pound sterling (PST) and the currency in the rest of the Europe is the euro (EUR).
Suppose that the PST appreciates relative to the EUR. For the following parts, you will not receive any credit without providing an explanation.
(1 pt each) In the UK:
- How would the export demand change? Why?
- How would the import demand change? Why?
- How would net exports change? Why?
(1 pt each) In the rest of Europe:
- How would export demand change? Why?
- How would import demand change? Why?
- How would net exports change? Why?
b. (4 pts) Suppose that the central bank in the UK (The Bank of England) decides to raise interest rates because it is worried about high inflation. As a result, interest rates in the UK become higher than interest rates in the REST OF EUROPE. This acts as an incentive for EUROPEAN investors to increase the amount of funds they invest in British (UK) interest bearing assets. In order to increase their purchases of those UK assets, which are priced in PST, EUROPEAN investors have to convert EUR into PST. This conversion, in turn, increases the demand for PST.
Based on the above information, please explain what will happen to the EUR----PST exchange rate. In other words, will the increased demand for PST, make PST gain value (appreciate) or lose value (depreciate) against the EUR? Why?
EUR? Why?