ECON 248 12.4 Interest Rate Determination In A Small Open Economy With Perfect Capital Mobility

The () predicts that interest rates in a small open economy with perfect capital mobility will equal those in the rest of the world

Interest Rate Parity Theory(IRP)

Interest Rate Parity states that the real interest rate on all comparable assets should be the () in all economies with access to world financial markets.

Same

In many Countries, ()( r ) are not equal to () (r*).

Domestic Real Interest Rates, Foreign Real Interest Rates

Canada is described as a () because it represents a small part of the world economy(Small Open Economy), which has full access to worldwide financial markets(Perfect Capital Mobility).

Small Open Economy With Perfect Capital Mobility

Perfect capital mobility implies that the domestic real interest rate must be () to the prevailing world real interest. This is shown as following:

Equal, r(Domestic real Interest Rate) = r^w (Worldwide Real Interest Rate)

If domestic interest rates are higher than foreign interest rates, borrowers will prefer (), causing domestic interest rates and the value of currency to (). This would cause domestic interest rates to eventually become the () and foreign interest rates.

Foreign Countries, Decrease(Depreciate), Same

The first reason why interest rate parity may not occur is due to the inherent () savers incur from loaning out their assets to borrowers.

Default Risk

Savers are also called (), while borrowers are called ().

Asset Buyers, Asset Sellers

The () the risk of borrowers not paying back savers(asset buyers), the higher () savers charge.

Higher, Interest

The difference of extra interest owed due to default risk is not due to (), meaning these interest rates are more likely to persist.

Arbitrage

The 2nd reason why interest rate parity may not occur is because an asset in one Country may not be a perfect () for an asset in another Country.

Substitute