Question

Suppose the nomianal interest rate for 1-year borrowing and lending in the U.S (i$) is currently 5%,while the nominal interest rate on 1 -year borrowing and leading in the U.K (1£) is 3%. Suppose,too, that nominal British pound/U.s. dollar exchange rate is to be £1.60/$ next year (i.e-1(£/$)e= £1.60/$).

A.According to the theory of Interest Rate Parity, what is the current equilibrium nominal exchange rate between the pound and the dollar (E0(£/$))?

B. All else equal, if the U.S. interest rate increased to 8%, what would be the new equilibrium

exchange rate?

C.All else equal (i.e. with both i$and E eat their initial levels), if the U.K. interest rate increased to 8%, what would the new equilibrium exchange rate be?

Answer 1

Think about the given issue, here we should expect that the "US" be the "outside nation" and "UK" be the nation of origin. Presently, "I" be the home pace of return and "i*" be the outside pace of return.

a). How about we accept that

i=3%,*=5% and E(H/F)=1.60.

In this way, as indicated by the UIP condition, we have, (1+i) = (1+i*)*(E1/E0)

= (1+3%) = (1+5%)*(1.6/E0),

= 1.03/1.05 = 1.6/E0,

= E0 = (1.6 * 1.05)/1.03.

= E0 = (1.6 * 1.05)/1.03,

= E0 = 1.63.

b). How about we expect that the "US" loan fee expanded to "8%", now as per the financing cost equality condition, we have.

= (1+i) = (1+i*)*(E1/E0)

= (1+3%) = (1+8%)*(1.6/E0)

= 1.03/1.08 = 1.6/E0

= E0 = (1.6 * 1.08)/1.03

= E0 = 1.68

c). Presently, expect that "UK" rate of interest expanded to "8%", now as indicated by the financing cost equality condition, we have.

= (1+i) = (1+i*)*(E1/E0),

=(1+8%) = (1+5%)*(1.6/E0),

=1.08/1.05 = 1.6/E0,

=E0 = (1.6 * 1.05)/1.08,

= E0 = 1.55.