The central theme of this chapter is that real interest rates are approximately the same across countries, a result known as the interest rate parity theorem. Three questions should immediately come to mind: What causes interest rate parity? Why is it only approximate? Why does it relate to the real interest rate rather than to the nominal interest rate?
The previous chapter explained how differing rates of inflation in trading countries affected the international balance between those countries and thereby influenced the exchange rate between their currencies. However, an important dimension of this international relationship was not addressed. One might expect differing inflation rates to give rise to different nominal interest rates, which could in turn influence the balance of payments and thus the exchange rate. The foregoing statement is misleading, however, because the exchange rate is affected by real, not nominal, interest rate differences; the purpose of this chapter is to explain why this statement is true.
