Question

Consider the following two currencies, the dollar ($) and the euro (€). Let R$ and R€
represent the interest rates on dollar deposits and euro deposits respectively and let E$/€
represent the current exchange rate defined in terms of dollars per euro.

Further, denote the expected exchange rate by Ee$/€

A. Write down the interest rate parity condition for this currency pair using the above
notations.

B. Underline the term representing the return on dollar deposits in Part A. Graph and
label this on a diagram with the vertical axis labelled “Exchange rate (E$/€)”and the
horizontal axis labelled “Rates of returns (in dollar terms)”.

C. Circle the term(s) representing the expected rate of return on euro deposits expressed
in terms of dollars in Part A. Graph and label this on the same diagram in Part B.

D. Indicate with “2” on your diagram the point where no one would be willing to hold
euro deposits and label the corresponding exchange rate as E2$/€.

Explain why that would be the case using the interest parity condition you have written down in A. What happens to the demand for dollars and euros?

E. Similarly, indicate with “3” on your diagram the point where no one would be willing
to hold dollar deposits and label the corresponding exchange rate as E3$/€.

Explain why that would be the case. What happens to the demand for dollars and euros?

F. Label the point on your diagram where the interest parity condition is satisfied as “1”
and label the exchange rate corresponding to this point as E1$/€.

Explain how points “2” and “3” are on your diagram would ultimately reach point “1”.

G. You have now graphed and explained the model of exchange rate determination.
Comparative static analysis can now be applied to this simple model.

Use the diagrammatic analysis of foreign exchange equilibrium and explain the effects of a
rise in the interest rate paid on dollar deposits from R1$ to R2$.
[Hint: Your answer should include an explanation of what happens to the relative
attractiveness of holding deposits in the two currencies (dollars and euros) at the original
exchange rate E1$/€ and how the new equilibrium exchange rate E2$/€ is achieved.]

Answer 1