Answer to Question #150890 in Macroeconomics for MOHSIN KHAN

Question

6.Consider a flexible exchange rate in the very short run, with the interest rate parity condition. Suppose that, today, the exogenous change consists of two changes: an exogenous increase in the foreign interest rate from 3% to 7% and an exogenous decrease in the expected future exchange rate (denoted set+1) from 1.0 to 0.98. Assume the domestic interest rate is fixed at 3%.

(a) Using numbers (with A, B, and C), explain how the exogenous change affects the exchange rate today.
(b) From the new equilibrium point, do domestic investors regard foreign bonds as a better investment than domestic bonds? Explain.

Answer 1

(a) An exogenous increase in the foreign interest rate from 3% to 7% will decrease the exchange rate and an exogenous decrease in the expected future exchange rate (denoted set+1) from 1.0 to 0.98 will also decrease the exchange rate.

(b) From the new equilibrium point, domestic investors regard foreign bonds as a better investment than domestic bonds.