Using an exchange rate diagram, explain how higher interest rates in Nordavia caused the krona to appreciate (Text C, paragraph 1).

Paragraph 1: Nordavia's economy grew strongly in Year 1 as consumer confidence and bank lending surged. Unemployment fell to 3.1% in Year 2, well below the 4.5% that the central bank estimates to be the natural rate of unemployment, and firms report that they cannot find enough workers. Economists describe the result as demand-pull inflation. About one third of the rise in prices, however, is explained by a jump in the world price of natural gas, which Nordavia imports.

Paragraph 2: The Central Bank of Nordavia has an inflation target of 2%. During Year 2 it raised its interest rate in steps from 2.0% to 6.0%. It expects the full effect on spending to take between 12 and 18 months.

Paragraph 1: About 70% of mortgages in Nordavia have a variable interest rate, and household debt is equal to 140% of annual household income. The monthly repayment on a typical mortgage has risen by 900 kronor (NKr 900), and sales of houses have fallen.

Paragraph 2: Rents in the capital city rose by 15% in Year 2, to an average of NKr 1,150 a month. The city council responded by imposing a maximum rent of NKr 1,000 a month. The landlords' association estimates that at this rent tenants want to rent 260,000 apartments but only 220,000 will be offered, and it reports that some owners are converting apartments into offices.

Paragraph 1: Higher interest rates have attracted financial investment from abroad, and there was an appreciation of the krona of 8% against the euro in Year 2. Exporters of furniture and timber complain that they are losing orders.

Paragraph 2: The central bank points out that a stronger krona makes imported goods and raw materials cheaper. Its forecast (Table 1) shows inflation falling in Year 3, but it also shows slower growth and higher unemployment.