If we assume that the international parity conditions all hold and Spain has a higher nominal interest rate than the United States, what implications does this suggest relative to inflation and its exchange rate for Spain's economy?
What will be an ideal response?
Answer: When all the parity conditions hold, real interest rates are equalized across countries, so the country's real interest rate should equal that of the United States. The country's higher nominal interest rate therefore must reflect a higher expected rate of inflation relative to the United States. Since the parity conditions hold, a higher expected rate of inflation implies that country's currency should be expected to depreciate relative to the dollar, and the currency will trade at a forward discount relative to the dollar.
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What will be an ideal response?
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