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Economy with fixed exchange rate

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Consider an economy with a fixed exchange rate, S. Through the problem, assume that the foreign interest rate, r*, remains constant.

1. Suppose that financial market participants believe that the government is committed to a fixed exchange rate. What is the expected exchange rate? According to the (uncovered) interest parity condition, what is the domestic interest rate?

2. Suppose that financial market participants do not believe that the government is committed to a fixed exchange rate. Instead, they suspect that the government will either devalue or abandon the fixed exchange rate altogether and adopt a flexible exchange rate.

If the government adopts a flexible exchange rate, financial market participants expect the exchange rate to depreciate from its current fixed value of S. Under these circumstances, how does the expected exchange rate compare with S? How does the domestic interest rate compare with r.

Reference no: EM133559567

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