Interest rate parity is a theory that suggests the difference in interest rate between two countries should equal the expected change in exchange rate over time. It helps determine the equilibrium exchange rate between two currencies. As Krugman (2018) states, “Today’s dollar/euro exchange rate is closely tied to people’s expectation about the future level of that rate.” If the interest rate in one country is higher than in another, investors will invest in higher returns in that country’s assets, increasing demand for that country’s currency. Thus, this demand can cause a currency to appreciate and adjust the exchange rate over time. However, if the interest rate in one country is lower, the demand for its currency is less, which can depreciate.

The interest rate parity is a mechanism that promotes and maintains equilibrium exchange rates, balancing interest rate differential and currency values. The historical table data explains the euro-dollar exchange rate. The interest rates vary depending on the economic performance each year. In the U.S. interest rate table, 2020 was 0.9 percent because the Covid 19 pandemic occurred in 2019 through 2020, forcing companies and firms to shut down for quite a while until they reopened to serve in 2020. Thus, each year, interest rates can affect economic performance. The exchange rates vary each quarter of a year.

Historical chart – Euro dollar exchange rate (Euro – USD).

 I found the interest rates for the first and last two in the euro area, but the rest of the years are not shown. We can see that 2022 and 2023 are entirely different because the economic activities occurred yearly.

Also, the direction of EUR/USD may reflect the strength of the EURO or USD economy. For example, if the U.S. economy grows steadily and problems arise in the EUR, this can cause the Euro to the dollar to fall (lite finance.org 2023). According to Lite Finance.org (2023), “most analysts expect the EUR/USD to have grown 1.15 by the end of 2023, and interest rates can reach 1.296 before 2027 if expected optimistic scenario play out correctly. It is reasonable to note that the euro price may fall below 1 USD.” The example explains how the change in economic situations and policy decisions will infinitely influence the market expectation in international trade, which can drive down fluctuation in the EUR/USD exchange rate. Again, it is crucial to understand that a large part of pricing is related to risk that will not be measured in advance.

 Based on the above historical rates, the U.S. interest rate and dollar/euro exchange rate explained various conditions of international trade exchange rates. Krugman (2018) stressed that “the exchange rate plays a central role in international trade because it allows consumers to compare the prices of goods and services across the board.” In international trade, the buyers and sellers try to compare the price of goods and services to buy and sell through the currency exchange rate. Consumers compare the rates and determine which exchange rate is higher to buy or invest their assets for higher returns by checking the relative prices of currencies in different sources, such as in the financial newspapers and some websites, to evaluate the difference between the exchange rates.

References

Krugman, P., Obstfeld, M. & Melitz, M. (2018). International Finance: theory and policy (11^th ed.). https://plus.pearson.com/courses/urn:xl-hed:course:7664602/products/JRCJEJNT8K4/pages/aead0551e2427cdfe45145b739e5488aa668391c1-id_toc14

Neufeld, D. (2020). Visualizing the 200-year history of U.S interest rates. https://advisor.visualcapitalist.com/us-interest-rates/

Trading Economics (2023). https://tradingeconomics.com/euro-area/interest-rate.

WSJ Market (2023). https://www.wsj.com/market-data/quotes/fx/EURUSD/historical-prices Mchugh, D. (2022). European’s Central Bank raises interest rates for the first time in 11 years. https://www.pbs.org/newshour/world/europes-central-bank-raises-interest-rates-for-first-time-in-11-years