What effect does high confidence in a currency peg have on interest rates?

A high level of confidence in a currency peg typically leads to interest rate differentials converging. When a country maintains a strong peg to another currency, investors perceive the exchange rate as stable and predictable. As a result, they tend to have a more uniform expectation of future interest rates between the pegged currencies.

This stability reduces the risk premium that investors might demand for holding assets in the pegged currency, leading to lower risk spreads over time. Consequently, similar interest rate expectations among investors lead to a convergence of interest rates between the two economies, as market participants adjust their expectations based on the perceived stability of the peg. It fosters a predictable economic environment where monetary policies in both countries are aligned in response to the stability of the peg.

In contrast, other options do not align with the effects of a stable peg. Interest rate differentials diverging would suggest increasing differences in rates due to instability or lack of confidence, while no effect on interest rates implies a static situation that typically does not occur with a strong peg. Increased volatility in interest rates is also counter to the stability that high confidence in a peg provides.