To finance its deficit, a State considers borrowing from a foreign economy. On the national market, the interest rate is 10% and the foreign rate of interest is 5%. The state decided to borrow 1,000 units of the domestic currency for a year (to simplify the calculation, assume that the rate of exchange is 1 unit of national money for 120 foreign units). As the foreign economy is in a very good situation, the exchange rate of the foreign currency is re-evaluated at 25% during the year. a. What is the increase in interest charged in the national currency after the re-evaluation? b. What is the resulting real interest rate of the borrowing? c. Is it still less costly to borrow in that foreign rate when con-verting it into domestic currency? d. If the foreign economy were to devaluate its currency to 25%, what will your answers to parts (a), (b), and (c) be? What will be the expectation about the interest rate of that money? e. What lessons do you draw for deficit financing?
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