Question

Question 4:

Why do interest rates vary among countries? Why are interest rates normally similar for those European countries that use the euro as their currency? Offer a reason why the government interest rate of one country could be slightly higher than the government interest rate of another country, even though the euro is the currency used in both countries

Answer 1

Interest rates in a country is determined by an interplay of the supply of funds and demand for funds for a given currency. Since there are many countries having Euro as currency, the supply and demand for the euro is sum total of supply and demand of all participating countries in aggregate. This does not vary among participating countries. Hence, the interest rates are normally similar for those European countries that use the euro as their currency.

However the government in different countries using Euro as a currency, do face different default risk. Hence, the interest rate will vary to a small extent across countries using Euro as a currency. Hence, the government interest rate in one country could be slightly higher than others that use the euro as the government may be subject to higher default risk. The incremental interest rate is the incremental risk premium on account of the incremental default risk that investors in that country may be facing.