Investor Expectations and Interest Rates

An economy's central bank operates under a policy framework that targets a path for total nominal spending. Investors in this economy widely expect the domestic currency to lose 4% of its value against major foreign currencies over the next year. If an otherwise identical economy with a stable currency offers a 2% nominal interest rate on its government bonds, what is the most likely nominal interest rate on a one-year bond in the first economy?

In an economy with a flexible exchange rate, if investors widely come to believe that the domestic currency will weaken significantly in the coming year, the nominal interest rates on government bonds are likely to decrease as a result of this change in expectations.

Explaining the Link Between Currency Expectations and Interest Rates

Analyzing the Impact of Currency Depreciation Expectations on Interest Rates

An international investor is considering two one-year government bonds, both considered equally safe from default.

• Bond A (from Country A): Pays a 3% nominal interest rate. The currency of Country A is expected to remain stable against the investor's home currency.
• Bond B (from Country B): The currency of Country B is widely expected to depreciate by 5% against the investor's home currency over the next year.

From the perspective of this investor, which of the following statements most accurately describes the nominal interest rate required for Bond B to be as attractive as Bond A?

An economy's central bank operates under a policy framework where it targets a path for total nominal spending and allows the currency's exchange rate to float freely. Match each market expectation for the currency's future value with its most likely effect on the domestic nominal interest rate, assuming all other factors remain constant.

In an economy where the currency's value is determined by market forces, if investors anticipate a future decline in the currency's exchange rate, they will require a higher ____ on domestic assets to offset the expected loss of value.

A government official in an economy with a flexible, market-determined exchange rate makes the following statement: 'Our central bank can create new money to fund government projects without affecting our borrowing costs. The interest rates on our government bonds are a domestic policy choice, and international investors will have to accept them.' Which of the following provides the most accurate critique of this official's statement?

Evaluating a Policy Claim on Borrowing Costs