We can rearrange the uncovered interest parity condition as follows:
Written this way, the equation tells us that beliefs matter. Suppose everyone in the market believes that the dollar will depreciate relative to the euro in the future: that is, everyone expects a decrease in the euro price of the dollar. This makes investment in euro-denominated assets a better deal since we will get a lot of dollars per euro in the future. Investors will respond by selling dollars now to buy euros. This increase in the supply of dollars will cause the current euro price of dollars to decrease.
Thus we see that if everyone expects the euro price of dollars to decrease in the future, then the euro price of dollars will decrease today. When we talk about the market for currencies, demand and supply today depend on what households and firms think about the future exchange rate.
We can also rearrange the equation to see what it tells us about exchange rate beliefs:
If the interest rate in Europe is greater than the interest rate in the United States, then the condition tells us that investors must be expecting the dollar to appreciate.
KEY TAKEAWAY
The nominal interest rate is the return on an asset in terms of money. The real interest rate is the return on an asset measured in terms of goods.
The yield curve describes the relationship between the (annual) return on an asset and its maturity. Normally, the yield curve is upward sloping: assets with a longer maturity have a higher annual return.
The Fisher equation links the real interest rate to the nominal interest rate. The real interest rate is approximately equal to the difference between the nominal interest rate and the inflation rate.
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Checking Your Understanding
If the nominal interest rate is 5 percent and the inflation rate is 3 percent, what is the real interest rate?
Can the real interest rate ever be negative?
What are the risks involved in investing in a foreign bank?
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