Interest Rates Drive Currency Appreciation in Floating Regimes

Steps:

• In a floating exchange rate, the currency's value is set by market supply and demand.
• Appreciation occurs when demand for the domestic currency rises relative to supply.
• Higher domestic interest rates attract foreign capital inflows, increasing demand for the currency.
• Thus, evaluate which variable boosts demand without increasing supply.

Why B is correct:

• Higher interest rates increase capital inflows seeking better returns, raising demand for the domestic currency per the interest rate parity condition.

Why the others are wrong:

• A: Larger budget deficits often lead to inflation or higher borrowing, increasing currency supply and causing depreciation.
• C: Higher general price levels erode purchasing power, making exports costlier and reducing currency demand (purchasing power parity).
• D: A bigger trade deficit means more imports, increasing supply of domestic currency to buy foreign goods, leading to depreciation.

Final answer: B