Question

Briefly discuss why the uncovered interest parity (UIP) and the goods market (GM) curves together determine the equilibrium value of the domestic price level and thus the equilibrium value of the real exchange rate under hard exchange rate peg.

Answer 1

For a given level of interest rate and income if the government decides to increase its spending then initially the income level in the economy will rise for the given level of interest rate. As income level rises for a given level of money supply, people will start to withdraw money from their speculative balances to finance their increased transaction needs. To keep the money market in equilibrium the interest rate will rise. From the other side, when the government decides to increase its spending then it needs to borrow from the market. It does this by selling securities. In order to make people buy the securities the government will have to offer higher interest rate.

Rise in the interest rate will cause capital inflow in the country, as investors looking for higher interest rate starts to invest in the economy. This will put pressure on the exchange rate to appreciate as the demand for the domestic currency increases, while supply of foreign currency increases.

However, since the country is following hard exchange rate peg, so the central bank of the country will intervene in the foreign exchange market to ensure that the domestic currency doesn’t appreciate. For this the central bank will sell domestic currency and buy foreign currency.