If a country has a credible peg with no risk of a depreciation or of other risks (e.g., default risk), then UIP implies that:
A) its interest rate should equal foreign interest rates.
B) its interest rate should be greater than foreign interest rates.
C) its interest rate should be less than foreign interest rates.
D) there should be no relationship between its interest rate and foreign interest rates.

Question

Quizplus · Accepted Answer

If a country has a credible peg with no risk of depreciation or default, then UIP implies that its interest rate should equal foreign interest rates. This is because investors will not demand higher interest rates to compensate for exchange rate risk or default risk. Therefore, capital flows will follow interest rate differentials, leading to interest rate parity.

If a Country Has a Credible Peg with No Risk