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Dear John,
Country X’s expected inflation rate is 5% per year, compared to 2% per year in country Y.
Country Y’s nominal interest rate is 4% per year and the current spot exchange rate between the two countries is 1.5 dinar per $1.In answer sheet working,
(1.04*1.05/1.02)-1=7.06%.
In other topic, you explained that:
As inflation is higher or lower, then so too the actual (nominal) interest rate will be higher or lower.
So if the nominal interest rate in country X = X,
then: (1 + X) / 1.05 = 1.04/1.02
Therefore 1+X = 1.05 x 1.04/1.02 = 1.0706
X = 0.0706 = 7.06%But sorry I still don’t really get it. Based on your explaination, I understand that the interest rate and inflation rate is directly proportion. But I still don’t understand based on which data of the question, this proportion of country X = country Y?
The exchange rate is 1.5 dinar per usd so how come the below rate is same:
X nominal interest rate/ X inflation rate = Y nominal interest rate/ Y inflation rate?You have not said which question you are referring to or what the question actually asked for (and which country operates in which currency).
In theory, the real interest rate in each country will be the same, and as you have written quite correctly that the real interest rate in country Y is 1.04 / 1.02 – 1 = 0.01961 (slightly less than 2%).
This is therefore (in theory) the real interest rate in country X as well, and therefore the actual/nominal interest rate in country X will be (1.05 x 1.01961) – 1, which is 0.706 or 7.06%.
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