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I am reading the CFA Level 2 Economics section and I came across this statement:

In emerging markets, capital flows may be restricted. In that case, impact of trade balance on exchange rate (goods flow effect) is greater than the impact of interest rates (financial flows effect). In such a case, expansionary fiscal policy or monetary policy leads to increases in net imports, leading to depreciation of domestic currency

My question is: how can expansionary fiscal policy which results in an increase in interest rate cause depreciation of currency?

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  • $\begingroup$ Where do you see that this expansionary policy is itself causing interest rates to rise? If capital flow restrictions are damping inflationary pressures then the increased stock of money minus the decrease in buying power might cause an increase in imports. This increase in imports increases demand for foreign currency and decreases demand for domestic currency. This method of exchange subverts the capital flow restriction and the depreciation follows. My best guess - but the question wasn't crystal clear for me. $\endgroup$ – 123 Jan 27 '15 at 4:29
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Where do you see that this expansionary policy is itself causing interest rates to rise?

If capital flow restrictions are damping inflationary pressures then the increased stock of money minus the decrease in buying power might cause an increase in imports. This increase in imports increases demand for foreign currency and decreases demand for domestic currency. This method of exchange subverts the capital flow restriction and the depreciation follows.

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