Currently, interest rate earnings in the US are taxed at the same rate of the income tax rate. Suppose the tax on interest rate earnings is removed. Explain the effects of a removal of this tax on the following variables: spot dollar-euro exchange rate, dollar interest rate, euro interest rate, US exports and US imports.

Explanation:

In the given scenario, the dollar interest rate increases as the tax on interest rate earnings is removed,  . Thus, the interest rate parity condition is given below:

 iH = iF + Ee/E – 1, where “iH=dollar interest rate” and “iF= euro interest rate” and “E=spot dollar-euro exchange rate”.

“iH” increases supposing the tax is removed , and in order to maintain the equality, “E” must decrease. Therefore, dollar-euro exchange rate decreases, Export will also decrease and import will increase. The euro interest rate will remain the same.

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