Why is interest rate parity NOT a perfect theory of real interest rate determination in a small open economy?
A) because of differences in prices
B) because of differences in tax treatments of returns earned on financial assets
C) because of Ricardian nonequivalence
D) because of perfect capital mobility

Question

Quizplus · Accepted Answer

Interest rate parity theory primarily focuses on the relationship between interest rates and exchange rates, assuming no arbitrage opportunities in the foreign exchange market. However, it does not perfectly predict real interest rates in a small open economy due to various real-world factors, such as differences in tax treatments of returns earned on financial assets. These differences can affect investors' net returns and thus influence capital flows and interest rates, deviating from the theory's predictions.

Why Is Interest Rate Parity NOT a Perfect Theory of Real