A number of situations can arise that will cause individuals to believe that policy makers might change the pegged value of a fixed exchange rate. Suppose financial market participants expect a devaluation in the future. The interest rate parity condition will be maintained if which of the following policy actions are taken in the current period?
A) A decrease in the domestic interest rate.
B) An increase in the domestic interest rate.
C) An increase in taxes.
D) A decrease in the pegged value of the domestic currency.
E) A decrease in government spending.

Question

Quizplus · Accepted Answer

According to the interest rate parity condition, a decrease in the domestic interest rate will cause the value of the domestic currency to decrease relative to other currencies, leading to a devaluation. Therefore, option A is incorrect. An increase in taxes or a decrease in government spending would not directly affect the exchange rate, so options C and E are also incorrect. A decrease in the pegged value of the domestic currency would lead to an immediate devaluation, so option D is also incorrect. In contrast, an increase in the domestic interest rate would make the domestic currency more attractive to investors, leading to an appreciation and maintaining the interest rate parity condition.

A Number of Situations Can Arise That Will Cause Individuals