On any given day interest rates varies from country to country. For example, US

Question

On any given day interest rates varies from country to country. For example, US government securities may pay 10% interest while comparable Japanese securities pay 5% interest

                                                                            A

Assume Japanese investors have access to US securities. Why would any of them invest in Japanese securities when they could earn a higher interest rate on US securities?

                                                                               B

Is it likely that any American investors would want to hold Japanese securities?

                                                                               C

Suppose that PPP holds exactly: interest rates in the United States and Japan are 10% and 5% and the US inflation rate is 5%. If international investors are to be indifferent between holding US and Japanese securities, what must the Japanese inflation rate be

Explanation / Answer

A. Apart from interest rates, the investors need to consider the expected inflation over the course of investment. Suppose the expected inflation in US is I(US) and Japan is I(J). Then,

real rate of return if investing in US = 10% - I(US)

real rate of return if investing in Japan = 5% - I(J)

It would make sense to invest in Japanese securities if,

real rate of return if investing in Japan > real rate of return if investing in US

or 5% - I(J) > 10% - I(US)

or I(US) > 5% + I(J)

or when inflation in US more than 5% of the inflation in Japan

(note we are assuming exchange rate to be constant during this period)

B. Using the similar argument as above, it would be profitable for US investors to invest in Japan if inflation in US more than 5% of the inflation in Japan

(note we are assuming exchange rate to be constant during this period)

C. Investors would be indifferent to choosing any investment if

real rate of return if investing in Japan = real rate of return if investing in US

or 5% - I(J) = 10% - I(US)

or 5% - I(J) = 10% - 5%

or I(J) = 0%

The Japanese inflation rate must be 0% for indifference to happen.

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