In an economy with a fixed exchange rate, the government or central bank sets the exchange rate at a specific level and intervenes in the foreign exchange market to maintain that rate.

(a) If financial market participants believe that the government is committed to a fixed exchange rate, the expected exchange rate is the fixed rate set by the government. This is because market participants expect the government to intervene in the foreign exchange market to maintain the fixed rate.

The uncovered interest parity condition is an economic theory that states that the difference in interest rates between two countries is equal to the expected change in exchange rates between the countries' currencies. If the exchange rate is expected to remain fixed, then the expected change in the exchange rate is zero.

Therefore, according to the uncovered interest parity condition, the domestic interest rate should be equal to the foreign interest rate (r*). This is because if the domestic interest rate were higher than the foreign interest rate, investors would buy the domestic currency to take advantage of the higher interest rate, which would put upward pressure on the domestic currency and violate the fixed exchange rate. Conversely, if the domestic interest rate were lower than the foreign interest rate, investors would sell the domestic currency to take advantage of the higher foreign interest rate, which would put downward pressure on the domestic currency and also violate the fixed exchange rate.

So, to maintain the fixed exchange rate, the domestic interest rate must be set equal to the foreign interest rate.

Question

In an economy with a fixed exchange rate, the government or central bank sets the exchange rate at a specific level and intervenes in the foreign exchange market to maintain that rate.

(a) If financial market participants believe that the government is committed to a fixed exchange rate, the expected exchange rate is the fixed rate set by the government. This is because market participants expect the government to intervene in the foreign exchange market to maintain the fixed rate.

The uncovered interest parity condition is an economic theory that states that the difference in interest rates between two countries is equal to the expected change in exchange rates between the countries' currencies. If the exchange rate is expected to remain fixed, then the expected change in the exchange rate is zero.

Therefore, according to the uncovered interest parity condition, the domestic interest rate should be equal to the foreign interest rate (r*). This is because if the domestic interest rate were higher than the foreign interest rate, investors would buy the domestic currency to take advantage of the higher interest rate, which would put upward pressure on the domestic currency and violate the fixed exchange rate. Conversely, if the domestic interest rate were lower than the foreign interest rate, investors would sell the domestic currency to take advantage of the higher foreign interest rate, which would put downward pressure on the domestic currency and also violate the fixed exchange rate.

So, to maintain the fixed exchange rate, the domestic interest rate must be set equal to the foreign interest rate.

Knowee AI · Accepted Answer

In an economy with a fixed exchange rate, the government or central bank sets the exchange rate at a specific level and intervenes in the foreign exchange market to maintain that rate.

(a) If financial market participants believe that the government is committed to a fixed exchange rate, the expected exchange rate is the fixed rate set by the government. This is because market participants expect the government to intervene in the foreign exchange market to maintain the fixed rate.

The uncovered interest parity condition is an economic theory that states that the difference in interest rates between two countries is equal to the expected change in exchange rates between the countries' currencies. If the exchange rate is expected to remain fixed, then the expected change in the exchange rate is zero.

Therefore, according to the uncovered interest parity condition, the domestic interest rate should be equal to the foreign interest rate (r*). This is because if the domestic interest rate were higher than the foreign interest rate, investors would buy the domestic currency to take advantage of the higher interest rate, which would put upward pressure on the domestic currency and violate the fixed exchange rate. Conversely, if the domestic interest rate were lower than the foreign interest rate, investors would sell the domestic currency to take advantage of the higher foreign interest rate, which would put downward pressure on the domestic currency and also violate the fixed exchange rate.

So, to maintain the fixed exchange rate, the domestic interest rate must be set equal to the foreign interest rate.

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