Suppose the domestic and foreign interest rates are both initially equal to 3%. Now suppose the domestic interest rate rises to 5%. Explain what effect this will have on the exchange rate. Also explain what must occur for the interest parity condition to be restored
What will be an ideal response?
Domestic bonds will have a higher return causing the demand for the domestic currency to rise. The dollar will appreciate. It will continue to appreciate as long as the return on domestic bonds exceeds the return on foreign bonds. This immediate appreciation will equal an expected depreciation of the domestic currency that equates the expected returns. So, the dollar will appreciate by 2%.
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