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Consider a situation of two countries, Home and Foreign, In which Homes interest rate is 11% and Foreign interest rate is 2%, the expected rate of depreciation of Home’s currency against Foreign is 5%, the risk premium, P, on domestic assets in domestic currency is 4%, and the exchange risk premium( again on domestic assets in domestic currency), Pe, is 1%.
a) What should be, Pd, the default risk premium (country premium) on domestic assets in domestic currency?
b) What should be the currency premium for the Home currency?
c) Is this situation consistent with uncovered interest parity? Explain why or why not.
d) How can the central bank cause the risk premium to decrease without changing the Home money supply? Be specific as to what happens on the central banks balance sheet.
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