10. Suppose the nominal interest rate for 1-year borrowing and lending in the U.
ID: 1122453 • Letter: 1
Question
10. Suppose the nominal interest rate for 1-year borrowing and lending in the U.S. (is) is currently 5%, while the nominal interest rate on 1-year borrowing and lending in the U.K. (e) is currently 3%. Suppose, too, that the nominal British pound/US. dollar exchange rate is expected to be £1.60/$ next year (i.e. -E(E/S) E1.60/S). According to the theory of Interest Rate Parity, what is the current equilibrium nominal exchange rate between the pound and the dollar (EolE/s)? All else equal, if the U.S. interest rate increased to 8%, what would be the new equilibrium exchange rate? All else equal (i.e. with both is and Ee at their initial levels), if the U.K. interest rate increased to 8%, what would the new equilibrium exchange rate be? a. b. c.Explanation / Answer
Consider the given problem, here let’s assume that the “US” be the “foreign country” and “UK” be the home country. Now, “i” be the home rate of return and “i*” be the foreign rate of return.
a). Let’s assume that “i=3%”, “i*=5%” and E1(H/F)=1.60.
So, according to the UIP condition, we have, “(1+i) = (1+i*)*(E1/E0)”.
=> (1+3%) = (1+5%)*(1.6/E0), => 1.03/1.05 = 1.6/E0, => E0 = (1.6 * 1.05)/1.03.
=> E0 = (1.6 * 1.05)/1.03, => E0 = 1.63.
b). Let’s assume that the “US” interest rate increased to “8%”, => now according to the interest rate parity condition, we have.
=> (1+i) = (1+i*)*(E1/E0), => (1+3%) = (1+8%)*(1.6/E0),
=> 1.03/1.08 = 1.6/E0, => E0 = (1.6 * 1.08)/1.03, => E0 = 1.68.
c). Now, assume that “UK” rete of interest increased to “8%”, => now according to the interest rate parity condition, we have.
=> (1+i) = (1+i*)*(E1/E0), => (1+8%) = (1+5%)*(1.6/E0),
=> 1.08/1.05 = 1.6/E0, => E0 = (1.6 * 1.05)/1.08, => E0 = 1.55.
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