Answer to Question #222802 in Macroeconomics for jay

Question

 Write down and explain the uncovered interest parity (UIP) condition. (a) What does it imply about the relationship between domestic and foreign interest rates? (b) Suppose that you expect the Ghana cedi to appreciate relative to the US dollar, which bond should you buy? What happens to the domestic (i.e., Ghana) interest rate relative to the US? Explain. 

Answer 1

1.The uncovered interest parity condition states that the difference in interest rates between two countries will be equal to the relative change in currency foreign exchange rates over the same period. If the uncovered interest rate parity does not hold, then there is an opportunity to make a risk free profit.

(a)

the uncovered interest parity controls the relationship between foreign and domestic interest rates and currency exchange rates. It assumes foreign exchange equilibrium, thus implying that the expected return of a domestic asset will be same as the expected return of a foreign asset after adjusting the change in spot rates of foreign currency exchange .

(b)

You should buy a US bond because it will have a risk free money market. It will trade at a forward premium against the Ghanian cedi.

The domestic interest rate of Ghana will appreciate relative to the domestic interest rate of US . This is because the US will be trading at a forward premium relative to Ghana while Ghana will be trading at a forward discount relative to the US.