PPP and Changes in the Real Interest Rate
Response to the following problem:
Assume that you believe exchange rate movements are mostly driven by purchasing power parity. The U.S. and Canada presently have the same nominal (quoted) interest rate. The central bank of Canada just made an announcement that causes you to revise your estimate of Canada's real interest rate downward. Nominal interest rates were not affected by the announcement.
Do you expect that the Canadian dollar to appreciate, depreciate, or remain the same against the dollar in response to the announcement? Briefly explain your answer.