1. raise domestic interest rates.
2. lower domestic interest rates if it is fully anticipated by asset holders.
3. raise domestic interest rates if it is fully anticipated by asset holders.
4. do none of the above.
Choose the correct option.
The correct answer is option 3. The domestic real interest rate equals foreign real interest rate plus a risk premium for holding domestic assets minus the expected rate of increase in the domestic real exchange rate. A fall in the expected rate of increase in the domestic real exchange rate, or alternatively, an expected rate of decline in that variable, will thus lead to an increase in the domestic real interest rate, given constancy of the risk premium and the rest of the world's real interest rate. The decline in the real exchange rate has to be anticipated by market participants, however, if a rise in the domestic real interest rate is to occur.
Notice that a rise in, or appreciation of, the domestic real exchange rate involves a rise in the price of domestic goods in terms of foreign goods. The real exchange rate, denoted by Q, can be expressed as
Q = Pd / ( Π Pf )
An appreciation of the real exchange rate involves an increase in Q. At the same time, an appreciation of the nominal exchange rate involves a fall in Π. This is because Π is the price of foreign currency in terms of domestic currency while Q is the price of domestic goods in terms of foreign goods---thus, holding the domestic and foreign price levels constant, a rise in Π is associated with a fall in Q.