Assume the interest parity condition holds and that initially i = i*. A decrease in the foreign interest rate will cause:
A) an increase in the demand for the domestic currency.
B) an expected depreciation of the domestic currency.
C) an increase in the exchange rate.
D) All of the above.
E) None of the above.

Question

Quizplus · Accepted Answer

The interest parity condition states that the expected return on domestic and foreign assets should be equal. If the foreign interest rate decreases, then the expected return on foreign assets will decrease. This will cause investors to sell foreign assets and buy domestic assets, which will increase the demand for the domestic currency and lead to an expected depreciation of the domestic currency. The exchange rate will also increase as the domestic currency becomes more valuable relative to the foreign currency.

Assume the Interest Parity Condition Holds and That Initially I