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Question

Difficulty: MediumForeign Exchange Market, Systems, and Exchange Rate Determination

Suppose a country experiences a significant surge in foreign portfolio inflows as overseas investors purchase its high-yielding domestic treasury bills. Under a flexible exchange rate system, what is the immediate impact of this financial inflow on the country's foreign exchange market?

  1. The demand curve for the domestic currency shifts to the right, causing the domestic currency to appreciate.Answer
  2. B
    The quantity demanded of domestic currency increases along the existing demand curve, leading to an official currency revaluation.
  3. C
    The supply curve of domestic currency in the foreign exchange market shifts to the right, causing the currency to depreciate.
  4. D
    The demand curve for domestic currency shifts to the left, prompting compulsory central bank intervention.

Answer

The demand curve for the domestic currency shifts to the right, causing the domestic currency to appreciate.
When foreign investors buy domestic treasury bills, they must first buy domestic currency using foreign currency. This increases foreign demand for the domestic currency, shifting its demand curve to the right and causing the domestic currency to appreciate naturally under a flexible exchange rate system.

Step-by-Step Solution

1
Identify the market reaction triggered by foreign portfolio investment.
Overseas investors require domestic currency to purchase local treasury bills.
Foreign investors must acquire domestic currency in the foreign exchange market to buy domestic assets.
2
Determine the curve shift in the foreign exchange market.
The demand curve for domestic currency shifts to the right.
An autonomous increase in foreign demand for local currency at any exchange rate causes a rightward shift of the demand curve.
3
Evaluate the exchange rate adjustment under a flexible system.
The equilibrium exchange rate rises, meaning the domestic currency appreciates.
Under a floating regime, excess demand bids up the price of the domestic currency relative to foreign currencies.

Key Concept

Foreign Exchange Market Demand Shifts and Exchange Rate Determination
Estimated Time:1m 0s
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Topics

Foreign Exchange Market, Systems, and Exchange Rate Determination

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