Question

Suppose that the interest rate on dollar accounts is equal to 2% (i_$ = 0.02), the interest rate on Polish zloty accounts is equal to 4.5% (i_zł = 0.045), and the expected exchange rate between the dollar and the zloty one year from now is e^e = 4 zł/$. Assume that the (uncovered) interest parity holds.

What would the spot rate, e, be if the expected exchange rate remains the same and the interest rate on Polish assets declines to i_zł = 0.02? (Answer in zł/$.)

Answer 1

The interest rate parity equation is

Using the above equation, the spot exchange rate can be obtained.

Solving for the spot exchange rate,

Spot exchange rate = 4 zł/$