Question

For a long time, interest rate differentials between European countries were high. Use the concept of interest parity to explain how interest rates moved closer and closer together as more countries joined the European Exchange Rate Mechanism, which introduced perfect capital mobility.

Answer 1

SOLUTION

Interest rate parity is the theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. Interest rate parity plays an essential role in foreign exchange markets, connecting interest rates, spot interest rates and foreign exchange rates. If one country offers a higher risk - free rate of another, the country that offers the higher risk - free rate of return will be exchanged at a more expensive future price than the current spot price. In other words, the interest rates parity presents an idea that there is no arbitrage in the foreign exchange markets. Investors cannot lock in the current exchange rate in one currency for a lower price and then purchase another currency from a country offering a higher interest rates. Interests rates system can also be used to control the behaviour of a currency, such as limiting rates of inflation. However in doing so, the pegged currency is then controlled by its reference value. As such, when the reference value rises or falls, it then follows that the value of any currency pegged to it will also rise and fall in relation to other currencies and commodities with which the commodities with which the pegged currency can be traded. In a fixed exchange rate system, a country's central bank typically uses an open market mechanism and is committed at all times to buy or sell its currencies at a fixed price in order to maintain its fixed ratio and hence the stable value of its currency in reference to which it is pegged. To maintain a desired exchange rates, the central bank during the time of private sector net demand for the foreign currency, sells foreign currency from its reserves and buys back the domestic money. This creates an artificial demand for the domestic money which increases its exchange rate value.

In 21st century, the currencies associated with large economies typically do not fix their fixed exchange rates to other currencies. The European exchange rate mechanism is also used as a temporary bases to establish a final conversion rate against the Euro from the local currencies of countries.