The interest rate parity theorem suggests that differences in observed nominal rates of interest in two countries should equal
A) differences in the expected rates of inflation between the two countries.
B) differences in the risk free rates of return between the two countries.
C) differences in the federal funds rates between the two countries.
D) differences in currency exchange rates between the two countries.

Question

Quizplus · Accepted Answer

The interest rate parity theorem suggests that differences in observed nominal rates of interest in two countries should equal differences in the expected rates of inflation between the two countries. This is because investors should earn the same real return on their investment regardless of the country in which they invest. If the nominal interest rate in one country is higher than that in another, but the rate of inflation is also higher, the real return on investment in both countries should be the same. Therefore, investors will prefer to invest in the country with the higher nominal interest rate to offset the higher inflation expectations.

The Interest Rate Parity Theorem Suggests That Differences in Observed