Question

Suppose the interest parity condition holds and that the domestic interest rate is greater than the foreign interest rate. What does this imply about the current versus future expected exchange rate? Explain.

Answer 1

When domestic interest rate is greater than foreign interest rate, it implies that return on domestic bonds is greater than return on foreign bonds. This increases the demand for domestic currency. Increase in demand increases the value of domestic currency. This leads to appreciation of current exchange rate.

Since the interest parity remains expected future exchange rate remains same. This is so because when current exchange rate appreciates demand for exports fall which reduces exchange rate back to its original level.