Question

Currently, interest rate earnings in the US are taxed at the same rate of
the income tax rate. Suppose the tax on interest rate earnings is removed. Explain
the effects of a removal of this tax on the following variables: spot dollar-euro
exchange rate, dollar interest rate, euro interest rate, US exports and US imports.

Answer 1

Here as the tax on interest rate earnings is removed, => the dollar interest rate increases. So, the interest rate parity condition is given by.

=> iH = iF + Ee/E – 1, where “iH=dollar interest rate” and “iF= euro interest rate” and “E=spot dollar-euro exchange rate”. As the tax is removed “iH” increases, => to maintain the equality “E” must decrease. So, dollar-euro exchange rate decreases, => Export will also decreases and import increases. The euro interest rate will not change.