Equilibrium Exchange Rates
The diagram shows the relative fluctuations in exchange rates of a Dollar ($) to a Euro (€) (vertical axis) following the changes in the rate of returns of deposits of each currency (horizontal axis). In the foreign exchange market, the value of a currency is determined by the returns for its deposit which is the interest rate. Consequently, they affect the supply and demand of each currency (Cecchetti, 2006).
The curve shows the changes in expected returns on Euro deposits, and at the intersection with return on dollar deposits at 1 is the equilibrium exchange rate when deposits of Euros and dollar give the same returns. It is referred to as the interest parity (Cecchetti, 2006). How do changes in interest rate of a currency relate to appreciation and depreciation? When the expected returns on Euros are less than the returns on dollar deposits, the dollar appreciates and the Euro depreciates. At this point 2, no one is willing to hold Euro deposits, and there is excess supply of Euros. When the expected returns on Euros are greater than on dollar deposits, the dollar depreciates and the Euro appreciates. This happens at point 3 leading to an excess supply of dollars because holding dollar deposits is less profitable than holding Euros.
Therefore, rates of returns are dependent on the expected changes in depreciation and appreciation of a currency as well as the interest rate (Cecchetti, 2006). For example, when rate of returns (R$) for a dollar fall, investors will sell dollars and buy Euros, leading to depreciation of the dollars. The curve for expected return on Euros will shift up when people expect the Euro to appreciate. This will be caused by increase in foreign exchange rates.
Cecchetti, S. (2006). Money, banking, and financial markets. Boston: McGraw-Hill/Irwin.