7. Inflation, interest rates, and exchange rates

Relative inflation rates affect interest rates, exchange rates, the overall economic health of a country, and the operations and profitability of multinational companies.

Consider the following statement:

Countries with higher inflation rates will have higher interest rates.

a) Based on your understanding of the relationship between relative inflation rates and exchange rates, identify whether the preceding statement is valid or invalid.

The statement is valid, because the nominal interest rate is the sum of the real interest rate plus inflation, so higher inflation rates would result in higher interest rates.

The statement is invalid, because the nominal interest rate is independent of the inflation rate.

b) If companies borrow from countries with low interest rates, the potential gains from the interest savings will likely be ? by the losses from currency appreciation.

a. offset b. multiplied

The currency of a country with a higher inflation rate than Japans inflation rate will ? over time against the yen.

a. depreciate b. appreciate