Question

Part 1: If the foreign interest rate is 15%, the current exchange rate is 10 and the expected future exchange rate is 11, what is the domestic interest rate according to the interest parity condition?

a. 25%

b. 14%

c. 11%

d. 10%

e. 5%

Part 2 If the foreign interest rate is 5%, the current exchange rate is 4 and the domestic interest rate is 10%, what is the expected future exchange rate according to the interest parity condition?

a. 4.0

b. 4.2

c. 4.4

d. 4.6

e. 5.0

Part 3: If inflation in Japan is 5% and in the U.S. it is 3%, then we would predict that the exchange rate (from the U.S. perspective) will:

a. fall by 5%.

b. fall by 3%.

c. fall by 2%.

d. rise by 2%.

e. rise by 8%.

Answer 1

1. Foreign exchange rate as per the interest rate parity condition, F = S(1+d)/(1+f)

d : domestic interest rate

S : Current exchange rate = 10

F : Expected future exchange rate = 11

f : Foreign interest rate = 15%

F= S(1+d)/(1+f)

d = F(1+f)/S - 1

d = 11(1+ 15%)/10 -1

=11 (1.15)/10 - 1

= 12.65/10 - 1

= 0.265

d = 26.5%

Hence, the domestic interest rate = 26.5%.

2. F= S(1+d)/(1+f)

= 4(1+0.10)/(1+0.0.5)

= 4(1.10)/1.05 = 4.10/1.05

F = 4.2%

Hence, the expected future exchange rate = 4.2% .

3. Inflation in Japan = 5%

Inflation in US = 3%

The exchange rate will fall by (5-3)% = 2%. Hence, option(C) is correct.