Asked by Esther Sagoe on Jul 27, 2024
Verified
The interplay between interest rate differentials and exchange rates, such that each adjusts until the foreign exchange market and the money market reach equilibrium, is called the
A) Purchasing Power Parity Theory.
B) Balance of Payments.
C) Interest Rate Parity Theory.
D) None of the options are correct.
Interest Rate Parity Theory
Interest Rate Parity Theory is an economic theory which suggests that the difference in interest rates between two countries is equal to the expected change in exchange rates between their currencies.
Exchange Rates
The rate at which one currency can be exchanged for another, influencing international trade and capital flow between countries.
Equilibrium
In economics and finance, a state where supply equals demand, and market forces are in balance, resulting in stable prices.
- Understand the theory underlying the interplay between interest rates and exchange rates, including purchasing power parity and interest rate parity.
Verified Answer
ND
Nikhil DhingraJul 28, 2024
Final Answer :
C
Explanation :
The Interest Rate Parity Theory explains the relationship between the interest rate differentials of two countries and their exchange rates. According to this theory, the difference in national interest rates for financial instruments of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, assuming no arbitrage opportunities. This ensures that the foreign exchange market and the money market are in equilibrium.
Learning Objectives
- Understand the theory underlying the interplay between interest rates and exchange rates, including purchasing power parity and interest rate parity.