Evaluating a Central Bank's Policy Claim
A central bank governor of Country A, which has a long-term inflation target of 4%, claims they can sustainably keep their policy interest rate 3 percentage points below the rate of their main trading partner, Country B, which has a 2% inflation target. Based on the principles of long-run equilibrium in international financial markets, explain why this claim is likely incorrect. In your explanation, describe what would be expected to happen to the exchange rate of Country A's currency over time if this policy were pursued.
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Consider two countries, A and B, both operating with flexible exchange rates and inflation-targeting monetary policies. Country A has an inflation target of 5%, while Country B has an inflation target of 2%. If Country B's nominal interest rate is currently 3%, what would be the approximate nominal interest rate in Country A, assuming the economies are in a long-run equilibrium where financial market expectations have fully adjusted?
Evaluating a Central Bank's Policy Claim
In a long-run equilibrium between two countries with flexible exchange rates and inflation-targeting policies, it is possible for the home country to maintain a nominal interest rate 5% higher than the foreign country while simultaneously achieving a stable exchange rate (zero expected depreciation), even if its inflation target is only 2% higher than the foreign country's.
In the context of a long-run equilibrium between two economies with flexible exchange rates and inflation-targeting central banks, match each economic differential to its corresponding role or equivalent value.
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