Interest Rate Differentials (ques)

Fredo Currency is currently valued at 2.50 per US dollar. Fredo deposit rates are 1% above US dollar deposit rates. All other things equal, which of the following scenarios would decrease demand for the Fredo on the Foriegn Exchange markets? Fredonia Interest Rate - US ********** Expected dollar-per-fredo interest rate differential ********** exchange rate in one year A. Increases ********** Decreases B. Increases ********** Increases C. Decresese ********** Decreases D. Decreases ********** Increases Could someone explain me how the answer to this is ‘C’ This is from Schwser Notes, Book-2, Economics, Pg 174. - Dinesh S

-if int rate differential decreases say to .50, money would flow out to other countries which have a higher int rate differential, ie demand for fredo decreases. Hence A & B ruled out… - current rate 2.50 F/USD. i.e. 0.40 USD/Fredo… if it increases say to 0.60 USD/ F, $ depreciates & Fredo appreciates…hence demand increases… vice versa… fredo should appreciate…i.e when rate falls to say 0.20… Hence option C

nisha, I am a bit skeptical about this bottoms-up approach you used to get to the answer, though your reasoning was perfectly OK, but I was looking our for a more of a top-down reasoning to get to the answer. Any takers?? - Dinesh S