Suppose that the domestic interest rate is 2% and that the foreign interest rate is 5%. Also assume that the domestic currency is expected to appreciate by 3% during the coming year. Given this information, we know that:
A) individuals will only hold domestic bonds.
B) individuals will only hold foreign bonds.
C) individuals will be indifferent about holding domestic or foreign bonds.
D) the interest parity condition holds.
E) the purchasing power parity holds.

Question

Quizplus · Accepted Answer

The expected return on domestic bonds is 2% (interest rate) plus 3% (currency appreciation) = 5%, which matches the foreign interest rate of 5%. Thus, individuals will be indifferent between holding domestic or foreign bonds as the expected returns are equal.

Suppose That the Domestic Interest Rate Is 2% and That