Final answer:
Interest rate parity signifies equal rates of return on hedged investments in different currencies, balancing out the differences in interest rates across countries. It does not mean that interest rates are identical across nations, but that the rates of return equalize when accounting for currency fluctuations.
Step-by-step explanation:
Interest rate parity means that there will be an equal rate of return on investments in different currencies once the differences in interest rates are accounted for, considering the risks of currency fluctuations. It does not necessarily mean that interest rates are the same in different countries. Instead, the concept implies that any difference in interest rates between two countries is offset by the exchange rate adjustments. This adjustment ensures that investors get an equal rate of return on investments in either country when hedged against exchange rate risk.
For example, if the interest rates are higher in a developing nation compared to the United States, it might attract U.S. investors initially. However, the anticipated appreciation or depreciation of currencies due to these interest rate differences means that over time, after accounting for currency risk, the rates of return should equalize. This equalization is a key point of the interest rate parity condition. This concept is different from purchasing power parity (PPP), which is about the exchange rate that equalizes the prices of internationally traded goods across countries.