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Discuss the implications of the interest rate parity for the exchange rate determination.
Answer: Presume that the forward exchange rate is roughly an unbiased predictor of the future spot rate, IRP can be illustrated as:
S = [(1 + I£)/(1 + I$)]E[St+1|It].
So the exchange rate is determined by the relative interest rates, and the supposed future spot rate, conditional on all the accessible information, It, as of the present time. So, one can say that expectation is self-fulfilling. As the information set will be constantly updated as news hit the market, the exchange rate will show a highly dynamic, random behavior.
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