Interest rate parity

The interest rate parity condition predicts that changes in the exchange rate between two countries equals the difference of the interest rates of the two countries.

Let’s take bank deposits in the U.S. and Mexico as an example. An American investor has 100 dollars to put on a bank deposit, earning 5 percent interest over one year. Alternatively, he can convert the dollars into peso at the 1 dollar = 15 peso exchange rate and invest the 1,500 peso at 10 percent interest in a Mexican bank.

If the money is deposited in the U.S., at the end of the year the investor will have 100 * 1.05 = 105 dollars.

If the money is invested in Mexico, at the end of the year the investor will receive 1,500 * 1.10 = 1,650 peso. The peso will be converted at the new exchange rate which we assume is 15.7. At that exchange rate, the investor will receive back 1,650 / 15.7 = 105 dollars.

Notice that the return on both bank accounts is the same when expressed in dollars. The interest rate on the U.S. bank account is 10 – 5 = 5 percentage points lower. However, during the year the Mexican peso depreciated by 0.7 / 15 = 5 percent. Although the Mexican deposit has a higher interest rate, when expressed in dollars the return is reduced because the peso depreciated.

In the end, the yield on both investments is the same. That is the prediction of the interest rate parity condition. In other words:

Mexican interest rate – U.S. interest rate = expected depreciation of the Mexican peso

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