Question

Using the uncovered interest parity (UIP) model of exchange rate determination in the short run, analyze the following.

A) When the US Fed shifted to monetary policy tightening the currencies of many emerging markets came under depreciation pressure (e.g. Argentina, Brazil, India, Indonesia, Brazil, South Africa, Turkey). Central banks of these countries responded to depreciation pressure by raising domestic interest rate, despite signs of weakening domestic economy. Explain why.

Answer 1

Ans. A contractionary monetary policy decreases the money supply in the economy which at given market demand for money leads to increase in interest rate. Which from the uncovered parity condition will lead to expected appreciation of dollar which will put a depreciation pressure on emerging markets. Due to this their central bank will decrease money supply increasing interest rate in their counties to which will offset the affect of increased interest rate in US.

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