The impact of increasing real interest rate when others are kept constant.
Answer to Problem 1CQQ
Option 'c' is correct.
Explanation of Solution
The foreign exchange market is the place of market where the participants are able to buy and sell different foreign currencies with exchange to the domestic currency. Here, the lonable fund interest rate theory applies. The lonable fund includes all the forms of credit of the economy which includes the loans, bonds, and the savings deposits.
Option (c):
When the real interest rate in the economy increases while all other variables are kept constant in the economy, the incentive to save more will increase in the economy. This is because when the interest rates are higher, the interest earned from the savings will be higher. Since the investment and the rate of interest are inversely related, the increase in the real interest rate will reduce the domestic investment of the economy. The higher real interest rate will attract the capital from around the world and thus the capital outflow will also decline. So, option 'c' is correct.
Option (a):
When the real interest rate is higher, it will fetch higher earnings to those who saves more. As a result of this, the private savings of the economy will increase and since the national savings are the summation of the private savings and the government savings, the national savings will increase. Since the investment and the rate of interest are inversely related, the increase in the real interest rate will reduce the domestic investment of the economy. Since option explains that the national savings will decline, option 'a' is incorrect.
Option (b):
When the real interest rate is higher, it will fetch higher earnings to those who save more. As a result of this, the private savings of the economy will increase and since the national savings are the summation of the private savings and the government savings, the national savings will increase. The higher real interest rate will attract the capital from around the world, and thus the capital outflow will also decline. Here also, the option explains that the national savings of the economy will decline, which is incorrect. So, option 'b' is incorrect.
Option (d):
The national savings will increase when the real interest rate of the economy is increased because the higher interest rate will provide higher returns to those who save. So, people will save more to earn more in interest. Since the national savings is the summation of the private and the government savings, it will also increase. So, the option explaining the national savings would decline is incorrect. So, option 'd' is incorrect.
Concept introduction:
Real interest rate: The real interest rate of the economy is determined by the interaction of the demand for lonable funds and the supply of lonable funds in the lonable fund market.
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