Use the graph of the exchange

The domestic rate of return is not dependent on the exchangerate and hence it is represeneted as a straight line in thediagram, The foreign asset rate of return is dependent on thexchange rate and this is represented as a downward slopping linein the diagram. This is because the domestic rate of return isinversely proportional to the exchange rate. When the rate ofreturn is high, there is inflow of capital in the country, which isthen left to mature. On maturity, when the investors get theirmoney back, the market is flooded with excess supply of the foreigncurrency which causes its value to depreciate, hence proving thenegative relationship.

i) When the domestic rate of return changes as a result of someinternal monetary policy irrespective of the exchange rate, thevertical line will shift. It can shift outwards or inwards, as isthe situation. In this case, let us assume that the domestic rateof return line shifts outwards, that is there is an increase in theinterest rate due to tight domestic monetary policy. As can be seenfrom the diagram, this means a higher interest rate which meansmore foreign investors will invest in the domestic economy. As aresult of this, there will be inflow of capital in the country andthe demand for domestic currency which the investors will need tobe able to invest in the economy will increase. This will cause anappreciation in the domestic currency, as is shown in thediagram.

ii) A change in the inflation rate will also affect the interestrates, in real terms. Inflation causes the real interest rates tofall. Hence, if the investors anticipate an increase in thedomestic inflation rates, then the rate of interest line will shiftto the left. As a result, there will be an outflow of capital fromthe economy, which will increase the amount of domestic currency incirculation in the market.The investors will now increase theirinvestment in the foreign economy, and since this increase isbrought about by no change in the interest rate or exchange rate ofthe foreign economy, this will shift the foreign interest curveoutwards. This shows that there will be a resultant depreciation ofthe domestic currency, or an appreciation of the foreign currency,as can be seen in the diagram.