Question text

Consider a financial investor in the euro area. Suppose that the Federal Reserve raises the interest rate in the U.S. from 1.5% to 4%. Assume that in the euro area the interest rate remains unchanged at 0%, and that the expected future exchange rate of the euro to the USD also remains unchanged at 1 Euro = 1.10 US dollars. Is the current nominal exchange rate of the euro to the USD going to increase, decrease or remain unchanged after the Federal reserve raises the interest rate if the interest parity condition holds and by how much? Please explain your calculations.

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