Answer to Question 3:

If the government is expected to follow a policy that will increase the domestic inflation rate in the future, the domestic nominal interest rate will rise as long as there is no fall in interest rates abroad and the differential risk from holding domestic as opposed to foreign assets is unaffected.

True or False?

The answer is true. The government can indeed bring about an increase in domestic interest rates if it can induce people to expect an increase in the future inflation rate. Naturally, this assumes that the government cannot affect interest rates in the rest of the world. It also assumes that there is no effect on the risk differential from holding domestic as opposed to foreign assets.

The correct answer can be obtained here from a straight-forward application of equation 5.

id = if + ρ + Eπ

The domestic interest rate will rise in response to an increase in  Eπ  associated with domestic inflation as long as  if  and  ρ  don't change.

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