Moderators, please tell me what is wrong in my logic:
1. Interest rates - When interest rates decrease, there is a cascading effect that happens in the money market and the forex market. In the money market, the fall in interest rates will cause more people to take loans, more people to convert their bonds to liquid cash, etc. Thus, the supply of money in the market will increase.
2. The interest rate fall also has an effect on the forex market. Since other countries now might have a better interest rate, "hot cash" (which is cash invested for the short term by foreign investors) will start leaving the country. Hence, the supply of foreign currency will decrease, causing the supply of forex curve to shift to the left and hence causes a depreciation of the local currency
3. This is not the only effect on the forex markets. Investors in the local country will also shift money to foreign countries where the interest rate is better. Therefore, the demand for foreign currency increases. This causes an increase in the demand for forex, causing a right shift in the demand curve and further depreciates the local currency
Since the local currency has depreciated, it is now more expensive to import and more profitable to export. The reverse applies for a decrease in interest rates
Now to the point on income taxes. This one is straightforward. An increase in income taxes (perhaps the question talks about import tariffs because that makes more sense to me than income taxes) will make the price of imports higher than it actually is and thus causes a reduction in the quantity of imports demand.
Coming to this question, my answer would be A and not D. I am hoping the moderators will correct me if I am wrong
Last edited: Apr 14, 2014