Question
Let's now consider a situation where because of the COVID-19 pandemic the businesses in country E have borrowed heavily in both dollars and domestic currency,
Let's now consider a situation where because of the COVID-19 pandemic the businesses in country E have borrowed heavily in both dollars and domestic currency, while their revenues are stagnant and entirely in local currency. In this situation, a depreciation of the domestic currency or an increase in the domestic interest rate next year could make it difficult for the indebted businesses to pay back their loans and many of them may go bankrupt. Suppose the prospect of such a debt crisis raises the risk premium in E this year. Assume as in part (a), that the central bank plans to keep the domestic interest rate constant this year and beyond. How would this prospect affect the spot exchange rate of country E's currency? Why? Please remember to explain your answers using concepts covered in this module of the course.
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