Assume that capital is not perfectly mobile and substitutable and that the interest rate in the United States is currently 5%, which includes a 1% risk premium associated with continued high budget deficits. Investors expect the euro to rise against the dollar by 2% and thus demand a _____ in the _____.
A) higher return equal to 7%; United States
B) higher return equal to 7%; European Union
C) lower return equal to 3%; United States

Question

Quizplus · Accepted Answer

Given the expectation that the euro will rise against the dollar by 2%, investors would demand a higher return for holding dollar-denominated assets to compensate for the expected currency depreciation. This is because the risk of holding assets in a currency expected to weaken (in this case, the dollar) increases, leading investors to seek higher returns to offset this risk. The 5% interest rate in the United States includes a 1% risk premium for budget deficits. If investors also expect the euro to appreciate by 2% against the dollar, they would demand an additional return to compensate for this expected currency loss, leading to a demand for a higher return in the United States, not in the European Union.

Assume That Capital Is Not Perfectly Mobile and Substitutable and That