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A researcher suggests that the US dollar – British pound exchange rate is a function of US and UK interest rates.

(a) Write an equation for this function.

(b) What signs would we expect for the parameters in this function and why?

(c) Give an example of parameter values that would lead the US interest rate to have three times the effect on the exchange rate as the UK interest rate.

Answer :

a) An equation for the function is Exchange rate = f (Iu, Il). b) The sign of the parameter of US interest rate would be positive and the sign of the parameter of UK interest rate would be negative. (c) An example of parameter values is Exchange rate (E) = a + b * Iu + c * Il3b = c.

The US dollar – British pound exchange rate can be regarded as a function of US and UK interest rates. The equation for this function is shown below:

a) Equation: Exchange rate (E) = f (US Interest rate (Iu), UK interest rate (Il))

Exchange rate is considered as a function of US and UK interest rates. Therefore, E is a function of Iu and Il.

Exchange rate = f (Iu, Il)

b) Expectation of the signs of the parameters of this function is given below:

If there is a positive relationship between the US interest rate and the exchange rate, then the parameter of US interest rate would be positive. This means that the increase in the US interest rate would lead to an increase in the exchange rate.

Conversely, if there is a negative relationship between the UK interest rate and the exchange rate, then the parameter of UK interest rate would be negative. This means that the increase in the UK interest rate would lead to a decrease in the exchange rate.

Therefore, the sign of the parameter of US interest rate would be positive and the sign of the parameter of UK interest rate would be negative.

c) Example:

Parameter values that would lead the US interest rate to have three times the effect on the exchange rate as the UK interest rate are shown below:

Exchange rate (E) = a + b * Iu + c * Il3b = c

This means that the effect of the US interest rate is three times greater than the effect of the UK interest rate on the exchange rate.

Learn more about Exchange rate:

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