Question

Suppose that the expected real interest rate in the United States is 9 percent per year while that in Europe is 3 percent per year. What do you expect to happen to the real dollar/euro exchange rate over the next year?

Answer 1

A higher interest rate in the US will make the European investors to invest in the US and that will lead to a flight of the capital in the Europe and increase in the demand for the Dollar. That will lead to an appreciation of the value of dollar in the market and Euro will depreciate against the dollar.

This will continue to the point where the Euro has depreciated so much that the difference in the exchange rate can be covered by the value of the currency or the European banks will increase the interest rate to the point where they are equal to the US rates.