Question

Assuming that the interest rate parity holds, and the balance of payments is equal to 0, show the effects of a decrease in the future expected exchange rate (R_t+1) on the following:

a) interest rate parity condition.

b) change in international transactions

c) change in the demand and supply of foreign currency

d) Change in the BOP.

Using the information above, how would the market mechanism correct the disequilibrium in the BOP.

Answer 1

From interest parity condition, we get: Hi+(R-R)/R For an increase in R a) i falls. For every decrease in expected exchange rate, the interest rate at home falls. b) With the fall in i,. people now invest more in foreign currency in anticipation of a higher interest income from the foreign currency. c) For the home country, the demand for home currency falls and the demand for foreign exchange falls for the home country. The converse is true for the foreign country, where supply of foreign exchange increases d) With the depreciation of home currency, home country's BOP deficit widens and conversely, foreign country's BOP surplus increases.