With fixed exchange rates and capital mobility, _____.[Hint: see page 18 of lecture 4B]Group of answer choicesinterest rates are higher in the home country than in foreign countriesinterest rates in the home country and in foreign countries are equalizedthe central bank in the home country has monetary autonomyinterest rates are lower in the home country than in foreign countries
Question
With fixed exchange rates and capital mobility, _____.[Hint: see page 18 of lecture 4B]Group of answer choicesinterest rates are higher in the home country than in foreign countriesinterest rates in the home country and in foreign countries are equalizedthe central bank in the home country has monetary autonomyinterest rates are lower in the home country than in foreign countries
Solution
Under a system of fixed exchange rates and capital mobility, the interest rate parity condition holds. This economic theory states that the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. If this were not the case, arbitrageurs could make a risk-free profit, which is not possible in an efficient market.
Here's the answer to your question:
With fixed exchange rates and capital mobility, interest rates in the home country and in foreign countries are equalized.
This is because if interest rates were higher in one country, investors would move their capital to that country to take advantage of the higher returns, until the rates are equalized. Similarly, if interest rates were lower in one country, investors would move their capital out of that country, until the rates are equalized. This process is known as interest rate arbitrage.
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