Suppose the dollar interest rate and the pound sterling interest rate are the sa
ID: 344501 • Letter: S
Question
Suppose the dollar interest rate and the pound sterling interest rate are the same, 6 percent per year What is the relation between the current equilibrium dollarfpound exchange rate and its expected future level? 0 A. Expected dollarpound exchange rate is higher tan the current one. B. Expected dollar/pound exchange rate is equal to the current one. O C. Expected dollar/pound exchange rate is lower than the current one. D- One cannot tol given the information above. Suppose the expected future exchange rate, $1,74 per pound, and the US interest rate remain constant, while Britain's interest rate rises to 11 peroent per year. What is the new equilibrium dollar/pound exchange rate? Now equilbrium exchange rate is sper pound. (Enter your response to the nearest penny)Explanation / Answer
1. Relation between current equilibrium dollar/pound exchange rate and its expected future level is equal because dollar interest rate and pound sterling interest rate are the same, i.e. 6 percent per annum and it has not changed.
2. Expected future exchange rate = $1.74 per pound
Dollar interest rate = 6% per annum
Pound Sterling interest rate = 11% per annum
New equilibrium exchange rate = (Expected future exchange rate x Pound sterling interest rate) / Dollar interest rate
= (1.74*1.11) / 1.06
= $1.82 per pound
This is because as the interest rates rise in the home country, the investment from other countries in the home country increases making the home country economy better and value of home currency also increase, making the exchange rates rise.
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