Question

Imagine that domestic and foreign currency bonds are imperfect substitutes and that investors suddenly shift their demand toward foreign currency bonds, raising the risk premium on domestic assets.

Which exchange rate regime minimizes the effect on output: fixed or floating?

Answer 1

Floating rate regime will always minimise the effect on the output, because it is always adjustable to the interest rates, because these interest rates are always issued with the assurance that they would be adjusted to the prevalent market, and hence all such risk which is related to the interest rate risk are completely eliminated, which is related to the floating rate regime.

The domestic and foreign currency bonds are the imperfect substitute as anan investor will suddenly shift their demand towards foreign currency bond so it will be reaching the risk premium on the domestic asset because there would be a risk related to to investment in the domestic currency because it will be exposed to the fluctuation in interest rate in the foreign currency.