Suppose two countries make a credible commitment to fix their bilateral exchange rate. In such a situation, we know that:
A) the interest rate in the two countries must be equal.
B) the uncovered interest parity condition no longer holds.
C) the real exchange rate must be constant as well.
D) neither country will run a trade deficit.
E) each country can freely allow its interest rate to diverge from that of the other country.

Question

Quizplus · Accepted Answer

When two countries commit to a fixed exchange rate, the interest rates in both countries must converge due to the arbitrage in the foreign exchange market. If the interest rates were different, it would lead to capital flows from the country with the lower interest rate to the country with the higher interest rate, putting pressure on the fixed exchange rate.

Suppose Two Countries Make a Credible Commitment to Fix Their