Explore BrainMass

interest rate parity concepts

Define and explain the interest parity concept using formal methods Explain IS and LM curve behavior and nominal interest rate in the domestic economy, and then to the exchange rate between the domestic economy and the rest of the world in the following situations. A weaker currency means it takes fewer foreign currency units to buy the domestic currency. (1) the domestic government increases spending 2) the domestic central bank decreases the money supply, 3) the foreign central bank increases.

Solution Preview

Interest rate parity implies that the domestic interest rate is equal to the foreign rate less the forward premium. The forward premium is the expected change in the exchange rate. This gives you a simple rule: if the domestic interest rate is above the foreign rate by x%, the forward exchange rate (for the maturity equivalent to the interest rate) will be less than the spot rate by x%. Lower interest rates yield higher exchange rates, which equalizes investments. If domestic interest rates exceed foreign, then the domestic currency should depreciate against the foreign by an amount that prevents arbitrage.

The slope of the LM curve is determined by k (the income elasticity of money demand) and h (the interest elasticity of money demand). Higher k implies steeper LM, higher h implies flatter LM. The LM curve slopes upward, ...