Question : Which of the following factors can lead to a currency depreciation?

Option 1: Increase in exports
   

Option 2: Rise in interest rates
 

Option 3: Political stability

 

Option 4: Trade surplus

Correct Answer: Rise in interest rates

Solution : The correct answer is b)  Rise in interest rates

An increase in interest rates can potentially lead to currency depreciation through the following mechanisms:

1. Capital outflows: Higher interest rates in a country can attract foreign investors seeking higher returns on their investments. However, if there is a perception of increased risk or uncertainty associated with the country, these investors may decide to withdraw their investments. This can result in a capital outflow, increasing the supply of the country's currency in the foreign exchange market and potentially causing its depreciation.

2. Carry trade unwinding: In a carry trade, investors borrow in a low-interest-rate currency and invest in a higher-interest-rate currency to earn the interest rate differential. When interest rates rise in the higher-yielding currency country, the profitability of the carry trade diminishes, leading investors to unwind their positions and sell the higher-yielding currency. This selling pressure can cause the currency to depreciate.

3. Reduced export competitiveness: Higher interest rates can make borrowing more expensive for businesses, potentially leading to reduced investment and production. This can impact a country's export competitiveness, as it may result in higher production costs and less competitive pricing. A decrease in export competitiveness can lead to a decline in demand for the country's exports and, consequently, a depreciation of its currency.

It's important to note that the relationship between interest rates and currency depreciation can be influenced by various other factors, including market expectations, inflation, and overall economic conditions. Therefore, while a rise in interest rates can contribute to currency depreciation in certain situations, it is not a definitive or exclusive determinant of currency movements.