Nominal and real interest parity In equation (18.4), we wrote the nominal interest parity condition as In the appendix to this chapter, we derive a real interest parity condition. We can write the...

Nominal and real interest parity


In equation (18.4), we wrote the nominal interest parity condition as

In the appendix to this chapter, we derive a real interest parity condition. We can write the real interest parity condition in a manner analogous to equation (18.4):

a. Interpret this equation. Under what circumstances will the domestic real interest rate exceed the foreign real interest rate?

Assume that the one-year nominal interest rate is 10 per cent in the domestic economy and 6 per cent in the foreign economy. Also assume that inflation over the coming year is expected to be 6 per cent in the domestic economy and 3 per cent in the foreign economy. Suppose that interest parity holds.

b. What is the expected nominal depreciation of the domestic currency over the coming year?

c. What is the expected real depreciation over the coming year?

d. If you expected a nominal appreciation of the currency over the coming year, should you hold domestic bonds or foreign bonds?