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Interest Rate Parity

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PPGPortal > Home > Concept Dictionary > I, J > Interest Rate Parity
 

Interest Rate Parity 

A theory of interest rate determination whereby the real interest rate on comparable financial assets should be the same in all economies with full access to world financial markets.

(Principles of Macroeconomics 4th Canadian Edition by Mankiw, Kneebone, McKenzie, and Rowe p.290)

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There are limitations to the interest rate parity for two reasons. First, financial assets carry with them the possibility of default. Thus, the higher the risk of default, the higher the interest rate; the interest rate on comparable financial assets would not be the same for varying levels of default risk. Secondly, financial assets offered for sale in different countries are not necessarily perfect substitutes for each other.

     

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