Is a depreciation of the dollar/euro exchange rate correlated with a decrease in the dollar return on U.S. deposits?
What will be an ideal response?
Assume that the Interest Parity is maintained, i.e.,
R$ = + ( – )/
Holding constant, one would expect a depreciation of the dollar/euro exchange rate (i.e. increase in ) to be correlated with a decrease in R$, dollar returns on euro deposits. However, the higher expected inflation in the U.S. implies an increase in the , the expected future dollar to euro exchange rate. Thus, the quantity ( – )/ goes up and, increases despite a depreciation in the current dollar to euro exchange rate, .
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