Suppose the domestic and foreign interest rates are both initially equal to 4%.Now suppose the foreign interest rate rises to 6%.Explain what effect this will have on the exchange rate.Also explain what must occur for the interest parity condition to be restored.

Question

Quizplus · Accepted Answer

The Answer is Domestic bonds will have a lower return causing the demand for the domestic currency to fall. The dollar will depreciate. It will continue to depreciate as long as the return on domestic bonds is less than the return on foreign bonds. This immediate depreciation will equal an expected appreciation of the domestic currency that equates the expected returns. So,the dollar will depreciate by 2%.

Suppose the Domestic and Foreign Interest Rates Are Both Initially