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Principles of Economics 2e

2nd Edition
Steven A. Greenlaw; David Shapiro
ISBN: 9781947172364

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BuyFindarrow_forward

Principles of Economics 2e

2nd Edition
Steven A. Greenlaw; David Shapiro
ISBN: 9781947172364
Textbook Problem

If a country’s currency is expected to appreciate in value, what would you think will be the impact of expected exchange rates on yields (e.g., the Interest rate paid on government bonds) in that country? Hint: Think about how expected exchange rate changes and interest rates affect a currency’s demand and supply.

To determine

Impact of expected currency appreciation on the yields.

Explanation

Yield on an investment is the return or the interest income on the investment. When the value of a currency improves vis-à-vis another currency, that currency is said to be have appreciated. Appreciation of a currency is indicated by a fall in the exchange rate.

Interest rate parity gives a relationship between change in yields (interest rates) and expected appreciation or depreciation. Foreign investors are induced by arbitrage and respond to higher yields in other countries. An expected appreciation of domestic currency would mean that demand for domestic currency falls. This would nullify the effect of higher yields available in domestic countries. To analyze the effect of an expected fall in exchange rate, we first write the equation for interest rate parity:

Interestrateparitycondition:it+1=it+Ee t+1 -EtEtÞit+1-it=Ee t+1 -EtEtÞi t+1-it= ΔE e E t where,

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