Predict Changes in the Euro–Dollar Exchange Rate
Remember, interest rate is a portfolio flow–related factor. Think of yourself as an investor who is deciding between a dollar- and a euro-denominated investment opportunity (with the same risk). Because the main subject is portfolio investment, the interest rate considered here is the real interest rate.
The real interest rate is defined as the difference between the nominal interest rate and the inflation rate.
This model predicts that the currency of the country with the higher real interest rate will appreciate. As an investor, and at the given exchange rate, you decide to invest in a security that gives you a higher real return. Suppose that the Euro-zone’s real interest rates are higher. The figure shows the implications of this change on the euro–dollar exchange rate.
When you look at the demand and supply curve, identify the investors along these curves. As the real interest rate on Euro-denominated securities increases, investors’ demand for dollar-denominated securities declines. Therefore, the demand for the dollar declines. In terms of the supply of dollars, investors are inclined to sell their dollars in exchange for euros to buy euro-denominated securities.
The supply curve for dollars increases. Both an increase in the supply curve and a decrease in the demand curve lead to the appreciation of the euro (or the depreciation of the dollar).