Suppose a deposit in New York earns 6 percent a year and a deposit in London earns 4 percent a year. Interest rate parity holds if the
A) U.S. dollar appreciates by 2 percent a year.
B) U.S. dollar depreciates by 2 percent a year.
C) U.K. pound depreciates by 2 percent a year.
D) None of the above answers is correct because interest rate parity requires that the interest rates be the same in both countries.

Question

Quizplus · Accepted Answer

Interest rate parity holds when the difference in interest rates between two countries is equal to the expected change in exchange rates between the countries' currencies. If a deposit earns more in New York (6%) than in London (4%), for parity to hold, the U.S. dollar must depreciate by 2 percent a year against the U.K. pound, making option B correct. This depreciation offsets the higher interest rate in the U.S., equalizing the returns when considering currency exchange rate changes.

Suppose a Deposit in New York Earns 6 Percent a Year