Higher domestic interest rates attract capital inflows, appreciating the currency

Steps:

• In a floating exchange rate system, the currency value is determined by supply and demand in forex markets.
• Identify variables affecting demand for the domestic currency: capital flows respond to interest rate differentials, while trade flows respond to income and prices.
• Higher interest rates increase foreign demand for domestic assets, boosting currency demand and causing appreciation.
• Rule out trade-related variables, as they typically increase currency supply via higher imports or reduced exports.

Why B is correct:

• Higher interest rates draw foreign investment seeking better returns, increasing demand for the domestic currency per the interest rate parity condition.

Why the others are wrong:

• A. Higher employment boosts income and imports, increasing currency supply and causing depreciation.
• C. Higher income levels raise import demand, worsening the current account and depreciating the currency.
• D. Higher price levels erode export competitiveness, reducing foreign demand for the currency and causing depreciation.

Final answer: B