Question

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.

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.