Question

In: Economics

Suppose the interest rate on a 1-year Canadian Treasury bill is 1.53 percent and the interest...

Suppose the interest rate on a 1-year Canadian Treasury bill is 1.53 percent and the interest rate on a 1-year U.S. Treasury bill is 1.7 percent. Assuming uncovered interest parity holds, we would expect

a)

the Canadian dollar to appreciate against the U.S. dollar 0.17 percent.

b)

the Canadian dollar to depreciate against the U.S. dollar by 0.17 percent.

c)

the nominal exchange rate between Canadian dollars and the U.S. dollar ($Ca/$US) to grow by 0.17 percent.

d)

Both a and c are true.

e)

Both b and c are true.

Solutions

Expert Solution

Option e) Both b and c are true.

A higher interest attracts foreign investor to invest in a home country and when foreign investors brings in capital to the home country, the demand for the home country's currency increases and the demand for the foreign investors' countries' currency decreases, thereby leading to appreciation in the home country's currency and depreciation of the foreign investors' countries' currencies.

Here, the interest rate on a 1-year Canadian Treasury bill is 1.53 percent and the interest rate on a 1-year U.S. Treasury bill is 1.7 percent. Since the interest rate on a 1-year U.S. Treasury bill is (1.7 - 1.53 = 0.17 percent) 0.17 percent greater than the interest rate on a 1-year Canadian Treasury bill, investors will buy more U.S. dollar until the the Canadian dollar depreciates against the U.S. dollar by 0.17 percent. Assuming uncovered interest parity holds,we would also expect the nominal exchange rate between Canadian dollars and the U.S. dollar ($Ca/$US) to grow by 0.17 percent. Hence option b and c are true.


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