Interest rate parity with illustrations
Can anyone explain Interest rate parity with illustrations?
Interest rate parity is a situtation where the earning by interest is equal in two different countries. It is sometime used to decide the foreign exchange rate.
For example how much you interest you get in india by investing 100, Same interest should get in USA. Based on this sometime currency rates are decided. For example Interest rate normaly in India is 10% and in USA its around 1-2%.
If you invest in india Rs.100 you get 10 Rs. as interest, so to equalise the earnings interest rate in USA is lower ie. 1-2%. You will get same return if you invest 100 (2$), in USA.
The concept to decide Exchange rate goes like this:
Higher the interest rate lower the currency value. As interst rate is higher in India, Indian currency is weaker compare to USA.
Hope you got it, please ask if you have any further doubts.