ABSTRACT
The use of the rate of interest for the domestic purpose of controlling domestic investment regardless of its relationship with interest rates abroad is in this way liable to cause violent swings in the exchange rate. If the divergence of interest rates were substantial, if the movement of foreign funds were sensitive to such divergences, and if the channels of trade did not respond much and/or responded only slowly to changes in relative prices, the swings in the exchange rate might have to be on a totally intolerable scale; indeed extreme circumstances can be imagined in which the currency would become virtually valueless. But even in much less extreme cases, the swings would lead to marked temporary changes in relative prices that would need subsequent reversal. In our example the sharp depreciation would lead to a marked increase in the cost of living due to temporary excessive rises in the cost of imports and to misleadingly high temporary boosts to the country's tradeable products.
