Question

Please, verify the following statement: if the uncovered interest rate parity holds, other things remaining constant, an increase in the U.K. nominal interest rate will increase the current value of the U.S. dollar against the British pound.

Answer 1

If the interest rate parity holds, other things remaining constant, an increase in the U.K. nominal interest rate will decrease the current value of the U.S. dollar against the British pound.

The uncovered interest parity (UIRP) condition between the U.S. and the U.K. two economies can be written as follows:

R$ = R£ + (Ee $/£ - E$/£)/E$/£

The left-hand side of the UIRP condition is the return to dollar deposits and the righthand side is the expected dollar return on pound deposits.

The UIRP condition must hold if the foreign exchange market is in equilibrium, that is, at the equilibrium exchange rate, deposits of both currencies must offer the same expected rate of return.

To study the effect of a rise in the U.K. interest rate R£ in the foreign exchange rate market,go through the following explanation

The return on dollar deposits is represented by the vertical line at R$, and the downward-sloping schedule shows the expected dollar return on pound deposits.

Initially the foreign exchange rate market is in equilibrium at point 1. Given the current exchange rate E 1 $/£ , the expected future exchange rate Ee$/£ and the U.S. interest rate R$ at point 1, a rise in pound interest rate increases the expected dollar return on pound deposits. As a result, the downward-sloping schedule shifts rightward. At the initial exchange rate E 1 $/£ (at point 1), the expected depreciation rate of the dollar is the same as before the rise in R£, so the expected dollar return on pound deposits now exceeds that on dollar deposits. In this situation anyone holding dollar deposits wishes to sell them for the more lucrative pound deposits. But because the return on dollar deposits is lower than that on pound deposits at the exchange rate E 1 $/£ , no holder of a pound deposit is willing to sell it for dollar at that rate. This Page creates an excess supply of dollars in the foreign exchange market at point 1. As dollar holders try to entice pound holders to trade by offering them a better price for pounds, the dollar/pound exchange rate rises toward E 2 $/£, that is, pounds become expensive in terms of dollars. Once the exchange rate reaches E 2 $/£, pound and dollar deposits offer equal returns and holders of dollar deposits no longer have an incentive to try to sell them for pounds, that is, there is no excess supply of dollars at point 2. The foreign exchange market is therefore in equilibrium at point 2. In rising from E 1 $/£ to E 2 $/£, the exchange rate equalizes the expected returns to the both types of deposit by reducing the rate at which the dollar is expected to depreciate in the future, thereby making pound deposits less attractive relative to dollar deposits. Thus, a rise in the U.K. interest rates, other things remaining constant, leads to a depreciation of dollar against pound.