Chapter 6

Exchange Rates, Interest Rates, and Interest Parity

Abstract

In this chapter, the relationship between interest rates and exchange rates are examined, and consideration is given to how exchange rates adjust to achieve equilibrium in financial markets. An example is worked through showing how covered interest arbitrage works, with a discussion of how well interest rate parity holds in the real world, with several reasons given for the deviations in interest rate parity that do occur. The differences between nominal and real interest rates are described, along with the role of inflation in determining interest rates. The Fisher equation and the interest parity equation are discussed as a means to determine how interest rates, inflation, ...

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