The nation of Arcadia pegs its currency, the Arc, to the currency of a major trading partner, where the prevailing interest rate is 3%. Due to recent economic instability in Arcadia, financial markets anticipate that the Arc will depreciate by 6% over the coming year, despite the official peg. To successfully defend the fixed exchange rate and prevent investors from moving their capital abroad, what is the minimum interest rate the Arcadian central bank must offer?
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Central Bank Policy for a Currency Peg
The nation of Arcadia pegs its currency, the Arc, to the currency of a major trading partner, where the prevailing interest rate is 3%. Due to recent economic instability in Arcadia, financial markets anticipate that the Arc will depreciate by 6% over the coming year, despite the official peg. To successfully defend the fixed exchange rate and prevent investors from moving their capital abroad, what is the minimum interest rate the Arcadian central bank must offer?
Economic Pressures on a Fixed Exchange Rate
Consequences of Defending a Currency Peg