Uncovered interest parity condition is written as R = R* + (Ee - E)/E. Explain intuitively...

Uncovered interest parity condition is written as R = R* + (Ee - E)/E. Explain intuitively what it means and why you expect it to hold, or not hold. Draw a diagram to show the equilibrium when the parity condition holds.

Expert Solution

International parity Conditions are financial conditions that would exist in ideal world.Uncovered interest rate parity condition is one of them.

Uncovered interest parity condition states that is written as R=R*+(Ee-E)/E.

This can also be written as R-R*=(Ee-E)/E

The equation means that the expected rate of exchange rate depreciation is just equal to the nominal interest rate differential.ln other words, difference in interest rates between two countries will equal the relative change in exchange rates over the same period.

Whether uncovered interest parity holds is a question of whether future exchange rate movements are assessed accurately by markets.lf yes , it will hold . otherwise it won't hold.Empirical research has also reached another conclusion that even though uncovered interest parity doesn't hold under usual conditions, of holds if monetary volatility is high, uncovered interest rate parity prevails.

Following diagram shows the equilibrium when the parity condition holds.

Rahul Sunny answered 2 years ago

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