The interplay between interest rate differentials and exchange rates, such that each adjusts until the foreign exchange market and the money market reach equilibrium, is called the
A) Purchasing Power Parity Theory.
B) Balance of Payments.
C) Interest Rate Parity Theory.
D) None of the options are correct.

Question

Quizplus · Accepted Answer

The Interest Rate Parity Theory explains the relationship between the interest rate differentials of two countries and their exchange rates. According to this theory, the difference in national interest rates for financial instruments of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, assuming no arbitrage opportunities. This ensures that the foreign exchange market and the money market are in equilibrium.

The Interplay Between Interest Rate Differentials and Exchange Rates, Such