Assume that capital is perfectly mobile and substitutable between country A and country B and that country A's currency is expected to rise by 3% against country B's. If the interest rate in country A is 4%, then the interest rate in country B will be
A) 1%.
B) 7%.
C) 4%.
D) 3%.

Question

Quizplus · Accepted Answer

If capital is perfectly mobile and substitutable between country A and country B, investors will move their capital from country B to country A to take advantage of the expected currency appreciation. This movement of capital will increase the demand for country A's currency, leading to an increase in its value. To offset this, the interest rate in country A will have to decrease. If the interest rate in country A is 4% and its currency is expected to rise by 3% against country B's, country B's interest rate will have to be higher than country A's to attract investors to lend in its currency. Therefore, the interest rate in country B will be 7% (4% + 3%).

Assume That Capital Is Perfectly Mobile and Substitutable Between Country