A number of situations can arise that will cause individuals to believe that policy makers might change the pegged value of a fixed exchange rate.Suppose financial market participants expect a revaluation in the future.The interest parity condition will be maintained if which of the following policy actions are taken in the current period?
A)a reduction in the pegged value of the domestic currency
B)an increase in i
C)a reduction in i
D)an increase in government spending

Question

Quizplus · Accepted Answer

According to the interest parity condition, if financial market participants expect a revaluation in the future, the domestic interest rate should be reduced to maintain the interest rate parity. This encourages investors to keep their funds in the domestic currency rather than moving them to other countries with higher interest rates. A reduction in the pegged value of the domestic currency (A) would make domestic goods and services cheaper, leading to higher imports and lower exports. This would lead to a capital outflow, and investors would likely sell domestic assets. An increase in i (B) would attract foreign capital, leading to an appreciation of the domestic currency, which is opposite to the expected revaluation. An increase in government spending (D) would increase the demand for domestic goods and services, leading to higher inflation and higher interest rates, which is again not in line with the interest parity condition. Thus, only a reduction in i (C) best aligns with maintaining the interest parity condition.

A Number of Situations Can Arise That Will Cause Individuals