When domestic and foreign currency bonds are imperfect substitutes, the domestic interest rate (R) can be written as
A) R = R - (Eᵉ -E)/E + ρ.
B) R = R - (Eᵉ -E)/E.
C) R = R + (Eᵉ -E)/E + ρ.
D) R = R - (Eᵉ +E)/E + ρ.
E) R = R - (Eᵉ -E)ρ.

Question

Quizplus · Accepted Answer

The correct formula that incorporates the expected change in the exchange rate (Eᵉ - E)/E and a risk premium (ρ) when domestic and foreign currency bonds are imperfect substitutes is R = R* + (Eᵉ -E)/E + ρ. This reflects that the domestic interest rate adjusts for expectations about currency depreciation or appreciation and includes a risk premium for holding domestic versus foreign bonds.

When Domestic and Foreign Currency Bonds Are Imperfect Substitutes, the Domestic