Determining a Central Bank's Long-Run Policy Rate

Suppose the central bank of a large foreign economy sets its policy interest rate at 2.5%. In a stable, long-run equilibrium, financial markets anticipate that the home country's currency will depreciate by 3% annually against the foreign currency. To maintain this equilibrium, what policy interest rate should the home country's central bank set?

Calculating the Equilibrium Policy Rate

In a stable, long-run equilibrium, if a home country's central bank sets its policy interest rate at 7% while a major foreign economy's rate is 4%, financial markets must expect the home currency to appreciate by 3% annually for the equilibrium to be maintained.

In a stable, long-run financial equilibrium, the central bank of Country A sets its policy interest rate at 5.5%, while the central bank of Country B (a major trading partner) maintains its rate at 2.0%. For this equilibrium to hold, financial markets must expect the currency of Country A to depreciate against the currency of Country B by ____% annually.

An economic analyst is examining the long-run financial stability of three small open economies (A, B, and C) relative to a large foreign economy. The foreign economy has a stable policy interest rate of 3.0%. The analyst has gathered the following data for the three small economies:

• Country A: Policy rate is 5.0%; expected annual currency depreciation is 2.5%.
• Country B: Policy rate is 6.5%; expected annual currency depreciation is 3.5%.
• Country C: Policy rate is 2.5%;

Evaluating a Central Bank's Policy Proposal

Central Bank Policy Dilemma

Assessing Financial Market Disequilibrium