Question

If the dollar interest rate is 4 percent, the euro interest rate is 6 perfect, then:

a) invest only in dollars if the exchange rate is expected to remain constant.

b) an investor should be indifferent between dollars and euros.

c) an investor should invest only in dollars.

d) an investor should invest only in euors.

e) Invest only in euros if the exchange rate is expected to remain constant.

Answer 1

In this scenario, an investor would be indifferent between dollars and euros due to the difference in interest rates and the resulting appreciation of the dollar and depreciation of the euro.

Step-by-step explanation:

In this scenario, an investor would be indifferent between dollars and euros. When the dollar interest rate is lower than the euro interest rate, international investors will demand more U.S. dollars to invest in U.S. government bonds, increasing the demand for dollars on the foreign exchange market. As a result, the exchange rate will appreciate, making dollars more valuable compared to euros.

However, the higher interest rate in euros makes holding euros more attractive, which increases the supply of euros in the foreign exchange market. The increased supply of euros leads to the depreciation of the euro against the dollar.

Therefore, given the difference in interest rates, investors would be indifferent between investing in dollars or euros, as the appreciation of the dollar is countered by the depreciation of the euro.