Interest rate parity in the theory of exchange rate determination
Em; margin top: 15px; ">. We know that the exchange rate is the relative price between the currencies of two countries. Like the pricing mechanism of other commodities, it is determined by the supply-demand relationship in the foreign exchange market foreign exchange is a kind of financial asset. People hold it because it can bring capital gains. When people choose to hold their own currency or a certain foreign currency, they first consider which currency can bring them greater benefits. The yield of each country's currency is first measured by the interest rate of its financial market. If the interest rate of a certain currency rises, the interest income of holding the currency will increase, attracting investors to buy the currency. Therefore, the interest income of holding the currency will be decreased and the attraction of the currency will be weakened if the interest rate falls. Therefore, it can be said that the interest rate rises, the currency is strong, the interest rate falls and the currency is weak;. According to the theory of interest rate parity, the forward discount rate of exchange rate is equal to the difference between the interest rates of the two countries; the forward discount rate of high interest rate will be pasted, and the forward discount rate of low interest rate will be increased. This is because, when the interest rates of the two countries are different, investors in the market will gain profits through Arbitrage Behavior, and the change of exchange rate will also be reflected in the arbitrage behavior.

. However, in practice, there is a certain deviation between the real exchange rate change and interest rate parity, which reflects transaction cost, foreign exchange control and various risk factors. Interest rate parity, from the perspective of capital flow, points out the close relationship between exchange rate and interest rate, which helps to understand the formation mechanism of exchange rate in the foreign exchange market, and also provides an effective way and means for the central bank to regulate the foreign exchange market. The theory of interest rate parity reveals the close relationship between the difference of interest rate level between the two countries and the spot exchange rate, forward exchange rate and expected spot exchange rate of the two countries.

. Later, Paul Einzig, a British economist, put forward the relationship between interest rate and exchange rate from the dynamic perspective in the 1950s, and put forward the theory of dynamic interest rate parity (or "interaction principle"). Then (in the 1950s-1970s) due to the rise of European dollar market and offshore financial market, the international financial pattern and capital flow appeared different characteristics, and had a profound impact on the determination of exchange rate, resulting in the modern interest rate parity theory. It mainly includes: the theory of non - replacement interest rate parity, replacement interest rate parity, dynamic interest rate parity, modern interest rate parity and so on. The theory of interest rate parity reflects the influence of interest rate, an important financial indicator, on exchange rate. The difference of interest rates among different countries leads to arbitrage, which leads to forward discount and exchange rate fluctuation. At the same time, the change of interest rate is also affected by capital flow. For example, when the time is out, the exchange rate of local currency rises, foreign exchange flows in a large amount, the basic currency increases, and the money supply rises sharply, which makes the market interest rate drop. The drop of market interest rate will inevitably reduce the inflow of arbitrage funds, reduce the money supply or slow down the increase speed of money supply. 2.   economic data solution:

reading the theory of interest rate parity deeply reveals why the market pays so much attention to the interest rate meeting of the central bank, especially the interest rate meeting of the Federal Reserve. The market also wants to look for the trend of central bank policy from the statement and minutes after the central bank meeting. In addition, the press conference after the meeting of the European Central Bank and the speeches of central bank officials also have a certain impact on the market. In the economic sense, when the foreign exchange market is balanced, the benefits of holding any two currencies should be equal, that is, RI = RJ (interest rate parity condition). Here, R stands for yield, I and j for currencies of different countries. If the gains from holding two currencies are not equal, arbitrage will occur: buying a foreign exchange and selling B foreign exchange. There is no risk in this arbitrage. Therefore, once the yields of two currencies are different, arbitrage mechanism will make the yields of the two currencies equal. That is to say, there is an inherent tendency and trend of equalization in the interest rates of different currencies, which is the key aspect of the impact of interest rate indicators on the trend of foreign exchange rate, and also the key for us to interpret and grasp the interest rate indicators for example, after August 1987, with the decline of the US dollar, people rushed to buy the high interest currency of the pound, resulting in the exchange rate of the pound from US $1.65 to US $1.90 in a short period of time, up nearly 20%. In order to limit the rise of the pound, the UK lowered interest rates several times in May June 1988, from 10% to 7.5% per year. With each interest rate cut, the pound will fall. However, due to the rapid depreciation of the pound and the increase of inflation pressure, the Bank of England was forced to raise interest rates several times, so the pound began to recover gradually under the condition of open economy, the scale of international capital flow is huge, which greatly exceeds the amount of international trade, indicating the great development of financial globalization. The impact of interest rate differences on exchange rate movements is more important than in the past. When a country tightens credit, the interest rate will rise, and interest rate differences will be formed in the international market, which will cause short-term funds to move internationally. Generally, capital flows from countries with low interest rates to countries with high interest rates. In this way, if one country's interest rate level is higher than that of other countries, it will attract a large number of capital inflows, reduce the outflow of domestic funds, and lead to the rush to buy this currency in the international market; at the same time, the balance of capital account has been improved, and the exchange rate of domestic currency has been increased. On the contrary, if a country looses credit, the interest rate will fall. If the interest rate level is lower than that of other countries, it will cause a large amount of capital outflow, a decrease in foreign capital flow, and a deterioration of capital account balance. At the same time, speculation on the foreign exchange market will sell this currency, causing the exchange rate to fall.