Interest rate differences between countries depend on
A) differences in expected inflation, but not on expected changes in the real exchange rate.
B) differences in expected changes in the real exchange rate, but not on expected inflation.
C) neither differences in expected inflation, nor on expected changes in the real exchange rate.
D) differences in expected inflation and nothing else.
E) differences in expected inflation, and on expected changes in the real exchange rate.

Question

Quizplus · Accepted Answer

Interest rate differences between countries depend on differences in expected inflation and expected changes in the real exchange rate. Higher expected inflation in a country typically leads to higher interest rates in that country to compensate for the loss of purchasing power of the currency. Similarly, if a country's currency is expected to depreciate in value relative to another country's currency, then investors will demand higher interest rates in that country to compensate for the increased risk. Therefore, differences in both inflation and expected changes in the real exchange rate can affect interest rate differences between countries.

Interest Rate Differences Between Countries Depend on