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Consider two assets: one denominated in US dollars and the other denominated in Canadian dollars. Assume floating exchange rates, no restrictions on international capital flows, risk-neutral investors, and no price rigidity. Suppose the spot exchange rate is denoted by E$/CD, the expected exchange rate is denoted by Ee$/CD, the forward exchange rate is denoted by F$/CD, and the interest rates on the US and Canadian assets are denoted by R$ and RC, respectively.
Consider the uncovered interest parity condition
Initial conditions:
Suppose the dollar interest rate = 6 %, the Canadian dollar interest rate = 6% (i.e., R$ = .06 and RC = .06) and the expected future exchange rate = $1 per Canadian dollar.
a. What is the spot exchange rate, E$/CD? Assuming that interest rates and expectations about the future exchange rate remain unchanged, will the spot exchange rate change over time?
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