Question

How does a situation in which the central bank targets the domestic interest rate differ from one in which capital mobility is perfect, so that the domestic interest rate is pinned down by uncovered interest parity?

Answer 1

Situation differs in the sense that there is a certain equilibrium in the latter market as capital mobility is perfect. ie. people are taking loans and interest rates are stable and affordable, Furthermore uncovered interest parity states that the difference between interest rates of two countries equals the relative change in foreign currency exchange rates over the same period. The expected return from domestic asset will equal the expected return from foreign asset after accounting for foreign currency spot rates change.

When the central bank targets the domestic interest rate, it is generally because inflation is too high in the economy or too low, there is no equilibrium, the central bank needs to intervene in order to stabilise the economy for its growth trajectory. Otherwise there is no capital mobility, people either think that the interest rates are too high or low and thus don't take loans and invest.