The left side is the return on investing in the United States. The terms on the right give the return on investing in Europe. When this condition holds, the returns on deposits in US and European banks are the same. This condition is called uncovered interest parity. Because we do not know the price of euros next year for sure, this equation does not hold exactly when we look at actual data from the past. That is, the actual exchange rates combined with the actual returns on deposits do not quite satisfy this equation. This does not contradict the theory. Hindsight is perfect. The important point is that if people hold similar beliefs, then uncovered interest parity will hold ahead of time. Using Uncovered Interest Parity to Understand the Exchange Rate We can rearrange the uncovered interest parity condition as follows: euro price of dollars = nominalinterestfactor ($)
nominal interest factor (EUR) × expected euro price of dollars next year.
Written this way, the equation tells us that beliefs matter. Suppose everyone in the market believes that the dollar will depreciate relative to the euro in the future: that is, everyone expects a decrease in the euro price of the dollar. This makes investment in euro-denominated assets a better deal since we will get a lot of dollars per euro in the future. Investors will respond by selling dollars now to buy euros. This increase in the supply of dollars will cause the current euro price of dollars to decrease. Thus we see that if everyone expects the euro price of dollars to decrease in the future, then the euro price of dollars will decrease today. When we talk about the market for currencies, demand and supply today depend on what households and firms think about the future exchange rate. We can also rearrange the equation to see what it tells us about exchange rate beliefs:
expected euro price of dollars next year euro price of dollars = nominal interest factor (EUR) nominal interest factor ($).
If the interest rate in Europe is greater than the interest rate in the United States, then the condition tells us that investors must be expecting the dollar to appreciate.