Intervention and Pegged Exchange Rates Interest rate parity exists and will continue to exist. The one-year interest rate in the United States and in the eurozone is 6 percent and will continue to be 6 percent. Assume that Denmark’s currency (called the krone) is currently pegged to the euro and will remain pegged to the euro in the future. You expect the ECB to engage in direct intervention by using euros to purchase a substantial amount of U.S. dollars in the foreign exchange market over the next month. Assume that this direct intervention is expected to be successful at influencing the exchange rate. Will the spot rate of the krone against the dollar increase, decrease, or remain the same as a result of the ECB’s intervention? Will the forward rate of the euro against the dollar increase, decrease, or remain the same as a result of the ECB’s intervention? Is the ECB’s intervention intended to reduce unemployment or reduce inflation in the eurozone? If the ECB decided to use indirect intervention instead of direct intervention to achieve its objective of influencing the exchange rate, would it increase or reduce the interest rate in the eurozone? Based on your answer to part (d), will Denmark’s interest rate increase, decrease, or remain the same as a result of the ECB’s indirect intervention?

FindFind

International Financial Management

14th Edition
Madura
Publisher: Cengage
ISBN: 9780357130698
FindFind

International Financial Management

14th Edition
Madura
Publisher: Cengage
ISBN: 9780357130698

Solutions

Chapter 6, Problem 27QA
Textbook Problem

Intervention and Pegged Exchange Rates Interest rate parity exists and will continue to exist. The one-year interest rate in the United States and in the eurozone is 6 percent and will continue to be 6 percent. Assume that Denmark’s currency (called the krone) is currently pegged to the euro and will remain pegged to the euro in the future. You expect the ECB to engage in direct intervention by using euros to purchase a substantial amount of U.S. dollars in the foreign exchange market over the next month. Assume that this direct intervention is expected to be successful at influencing the exchange rate.

  1. Will the spot rate of the krone against the dollar increase, decrease, or remain the same as a result of the ECB’s intervention?
  2. Will the forward rate of the euro against the dollar increase, decrease, or remain the same as a result of the ECB’s intervention?
  3. Is the ECB’s intervention intended to reduce unemployment or reduce inflation in the eurozone?
  4. If the ECB decided to use indirect intervention instead of direct intervention to achieve its objective of influencing the exchange rate, would it increase or reduce the interest rate in the eurozone?
  5. Based on your answer to part (d), will Denmark’s interest rate increase, decrease, or remain the same as a result of the ECB’s indirect intervention?

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