*Could you help me to check if I answered it correctly*

Consider models of Exchange rate determination.

Assume interest parity holds and the return on a domestic asset is equal to the covered return

on a foreign asset. In the domestic economy the central bank decreases the interest rate in

order to stimulate the economy.

Using both covered and uncovered interest parity conditions identify the direction variables

would be expected to move in response to the policy changes in order to restore parity. What

role do expectations play if any in this process? (5 Marks)

*My answer*

Using Covered Interest Parity Conditions:

If covered interest parity does not initially hold, then market participants would borrow as

much as possible in Australia, buy US$ on the spot market, invest in the US and sell US$

forward. This would place upward pressure on exchange rate and on domestic rate of interest

and put downward pressure on forward rate by selling bonds that will cause a fall in the price

of bonds and increase in interest rate and place downward pressure on US interest rate by

buying bonds that will cause fall in interest rate.

This will continue until the CIP condition holds

Using Uncovered Interest Parity Conditions:

Holding domestic currency or foreign currency deposits rewards the investor with domestic

currency interest. Holding foreign currency deposits also rewards investors with the loss or

gain on the foreign currency equal to the rate of increase in the foreign currency. Any

expected loss (gain) in the form of an decrease (increase) in the value of the foreign currency

must be compensated for by an higher (lower) interest rate on the foreign currency to hold

UIP to keep the investors remain indifferent between domestic deposits and foreign deposits.

The effect of expectations on the exchange rate

An increase in exchange rate will increases the expected AUD return on foreign currency

assets. In return Market participants would purchase US$ on the spot market, placing upward

pressure on exchange rate e, until uncovered interest parity UIP holds. Therefore, an increase

in the expected exchange rate will increase the current spot exchange rate.