Question at position 10 Under a flexible exchange-rate system, the Indian rupee will appreciate against the Japanese yen when Japan’s money supply decreases while India’s money supply increasesJapan’s economy enters a recession, but India’s does notIndia has a trade deficit with JapanIndia’s inflation rate exceeds Japan’sreal interest rates in India increase relative to those in Japan

Question

BlackTom AI · Accepted Answer

Higher real interest rates in India relative to Japan attract capital into India, increasing demand for the rupee and causing it to appreciate.

1) Relevant concepts
- Under a flexible exchange-rate system, currency values are determined by supply and demand in foreign exchange markets. 
- Real interest rates (nominal rate minus expected inflation) determine real returns on assets; higher real rates attract foreign capital. 
- Capital inflows increase demand for the domestic currency, causing appreciation; capital outflows do the opposite.

2) Step-by-step reasoning
- If real interest rates in India rise relative to Japan, investors shift funds toward Indian assets to obtain higher real returns.
- To buy Indian assets, foreign investors must convert yen into rupees, increasing demand for rupees and/or reducing supply of rupees to the FX market.
- The increased demand for rupees pushes up its price relative to the yen, i.e., the rupee appreciates.

3) Intermediate/calculation illustration
- Suppose expected real return in India = 3% and in Japan = 1%. A foreign investor moving $1,000 equivalent into India must exchange yen for rupees. The greater expected return induces net capital inflow ΔK > 0. Increased demand for rupees shifts the FX demand curve right; equilibrium exchange rate moves to a higher rupee value per yen (appreciation). (No complex algebra needed beyond recognizing the sign of capital flows and their effect on demand for currency.)

4) Why the correct answer is correct
- Real returns determine cross-border investment decisions. An increase in India’s real rates raises the attractiveness of rupee-denominated assets, creating capital inflows and upward pressure on the rupee’s value versus the yen.

5) Why other options are incorrect
- "Japan’s money supply decreases while India’s increases": Lower Japanese money supply tends to raise Japanese interest rates and strengthen the yen while an increased Indian money supply tends to weaken the rupee — this would not cause rupee appreciation.
- "Japan’s economy enters a recession, but India’s does not": A Japanese recession could weaken the yen, but the effect is indirect and depends on monetary/fiscal responses; it is not as directly predictive as a relative change in real interest rates.
- "India has a trade deficit with Japan": A trade deficit tends to put downward pressure on a currency (more imports → more selling of domestic currency), not appreciation.
- "India’s inflation rate exceeds Japan’s": Higher inflation in India erodes real value and tends to depreciate the rupee relative to the yen.

6) Conclusion
Thus the rupee will appreciate when real interest rates in India increase relative to those in Japan — matching the provided correct answer: "real interest rates in India increase relative to those in Japan."

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