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Suppose investors have £1,000, and can choose between UK and EU bonds for financial investment in international markets. Both type of bonds offer 3% interest rate and the current and future nominal exchange rate is equal to 1.15 euros per pound (the expected future exchange rate is taken as given).
a. Suppose now EU interest rate decreases from 3% to 1%. Is the interest parity condition respected or does it no longer hold
b. Now suppose the investors engage in arbitrage. How will the investors react? What would be the impact on current exchange rate? Discuss
c. The interest parity condition or the uncovered interest parity (UIP) relation is a bond market equilibrium condition for an open economy that allows for free capital movement. Using the IS-LM-UIP model discuss, the relative effectiveness of fiscal and monetary policy in an open economy, in the short run.
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