Intervention and Pegged Exchange Rates
Response to the following problem:
Interest rate parity exists and will continue to exist. The 1-year interest rates in the United States and in the eurozone is 6 percent and will continue to be 6 percent. Assume that the country of Latvia's currency (called the Lat) is presently pegged to the euro and will remain pegged to the euro in the future. Assume that you expect that the European central bank (ECB) to engage in central bank intervention in which it plans to use euros to purchase a substantial amount of U.S. dollars in the foreign exchange market over the next month.
Assume that this direct intervention is expected to be successful at influencing the exchange rate.
a. Will the spot rate of the Lat against the dollar increase, decrease, or remain the same as a result of central bank intervention?
b. Will the forward rate of the euro against the dollar increase, decrease, or remain the same as a result of central bank intervention?
c. Would the ECB's intervention be intended to reduce unemployment or reduce inflation in the eurozone?
d. If the ECB decided to use indirect intervention instead of direct intervention to achieve its objective of influencing the exchange rate, would it increase or reduce the interest rate in the eurozone?
e. Based on your answer to part (d), will the interest rate of Latvia increase, decrease, or remain the same as a result of the ECB's indirect intervention?