Economics Exchange Rate Systems Questions Long
Interest rate parity is a concept in economics that explains the relationship between interest rates and exchange rates in a global financial market. It suggests that the difference in interest rates between two countries should be equal to the percentage difference between the forward exchange rate and the spot exchange rate.
To understand this concept, let's consider two countries, Country A and Country B, with different interest rates. According to interest rate parity, if the interest rate in Country A is higher than in Country B, investors will be attracted to invest in Country A to earn higher returns. This increased demand for Country A's currency will cause its value to appreciate relative to Country B's currency.
Conversely, if the interest rate in Country A is lower than in Country B, investors will be less inclined to invest in Country A, leading to a decrease in demand for its currency. This decreased demand will cause the value of Country A's currency to depreciate relative to Country B's currency.
The relationship between interest rates and exchange rates is further influenced by the forward exchange rate. The forward exchange rate is the rate at which two parties agree to exchange currencies at a future date. If the forward exchange rate is higher than the spot exchange rate, it implies that the market expects the currency of Country A to appreciate in the future. This expectation is usually driven by higher interest rates in Country A. On the other hand, if the forward exchange rate is lower than the spot exchange rate, it suggests that the market expects the currency of Country A to depreciate in the future, which is typically associated with lower interest rates in Country A.
Interest rate parity suggests that any discrepancy between the interest rate differential and the forward-spot exchange rate differential will be eliminated through arbitrage. Arbitrage is the practice of taking advantage of price differences in different markets to make a profit. In the context of interest rate parity, investors will engage in arbitrage by borrowing in the country with lower interest rates and investing in the country with higher interest rates. This arbitrage activity will lead to an equalization of interest rates and exchange rates, ensuring that interest rate parity holds.
In summary, interest rate parity explains the relationship between interest rates and exchange rates. It suggests that the difference in interest rates between two countries should be equal to the percentage difference between the forward exchange rate and the spot exchange rate. Any deviation from this equilibrium will be corrected through arbitrage activities, ensuring that interest rate parity holds in the long run.