Answer to Question 3:

1. will lead to an increase in both nominal and real interest rates in the domestic economy.

2. will lead to an increase in domestic real interest rates but not nominal rates.

3. will lead to an increase in the rate of depreciation of the domestic real exchange rate.

4. will lead to a decline in both nominal and real domestic interest rates as long as foreign interest rates are constant.

Choose the correct option.

The correct option is 1. An increase in either foreign exchange risk or country-specific risk will increase the risk premium  ρ  and raise both the nominal and real domestic interest rates. While a change in the expected rate of depreciation of the real exchange rate could possibly lead to a different evaluation of the level of foreign exchange risk, there is no reason to expect a causal relationship running in the opposite direction. Option 4 gets the sign wrong.

The relevant equations are

     i_d = i_f + ρ + E_π

and

     r_d = r_f + ρ - E_q

The risk premium  ρ  is the sum of the foreign exchange risk premium  ρ_x  and the country-specific risk premium  ρ_d  so that an increase in  ρ_x  increases  ρ  and, as a result, both  i_d  and  r_d .