Assume that capital is perfectly mobile and substitutable and that the interest rate in the United States and the European Union is currently 5%. Investors expect the euro to rise against the dollar by 2% and they 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 in the United States to compensate for the expected depreciation of the dollar. This is because, with capital mobility, investors can choose to invest in the currency area offering the highest expected return. If they expect the euro to appreciate, the return on investments in the euro area effectively increases when measured in dollars. To attract or retain capital in the United States, a higher return would be necessary, making the correct answer a higher return equal to 7% in the United States.

Assume That Capital Is Perfectly Mobile and Substitutable and That