In the interest rate parity condition with imperfect substitutes and a risk premium of ρ
A) an increased stock of domestic government debt will raise the difference between the expected returns on domestic and foreign currency bonds.
B) a decreased stock of domestic government debt will raise the difference between the expected returns on domestic and foreign currency bonds.
C) an increased stock of domestic government debt will reduce the difference between the expected returns on domestic and foreign currency bonds.
D) an increased stock of domestic government debt will have no effect on the difference between the expected returns on domestic and foreign currency bonds.
E) a decreased stock of domestic government debt will have no effect on the difference between the expected returns on domestic and foreign currency bonds.

Question

Quizplus · Accepted Answer

An increased stock of domestic government debt typically leads to a higher risk premium (ρ) because investors perceive a greater risk of default or inflation. This, in turn, raises the difference between the expected returns on domestic and foreign currency bonds, as investors demand higher returns to compensate for the increased risk associated with holding domestic bonds.

In the Interest Rate Parity Condition with Imperfect Substitutes and a Risk