Question

# Suppose that in the initial equilibrium the Canadian dollar interest rate and euro interest rates are...

Suppose that in the initial equilibrium the Canadian dollar interest rate and euro interest rates are equal at 3% (R1$= R€ = 0.03) and the expected exchange rate equals$1.50 (Ee1$/€ = 1.50). The expected exchange rate then decreases to$1.47 (Ee2$/€ = 1.47) with no change in the euro interest rate. What is the new value of the Canadian interest rate (R2$) which will keep the equilibrium exchange rate unchanged at E1\$/€? Show your method of calculation.

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Answer #1

Given that

Canadian dollar interest rate and euro interest rates are equal at 3%

Assume that “RH” be the Canadian dollar interest rate, “RF” be the Euro interest rate, “Ee=the expected exchange rate” and “E=actual exchange rate”. According to UIP the following condition holds.

RH = RF + [Ee/E – 1]

0.03 = 0.03 + Ee/E – 1

Ee/E = 1

Ee = E

E = 1.5. So, the actual exchange rate is “E = 1.5”.

Let’s assume the expected exchange rate decreases to 1.47, and the actual exchange rate remains at 1.5 implied according to UIP the following condition holds.

RH = RF + Ee/E – 1

= 0.03 + 1.47/1.5 – 1

= 0.01

= 1%,

RH = 1%.

So, as the expected exchange rate decreases the “dollar return” also decreases.

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