Final answer:
The theory of Uncovered Interest Parity defines the equilibrium exchange rate as the rate at which the foreign and domestic rate of return are equal, leading to no incentive for investors to shift funds in search of higher returns. Higher interest rates in a country result in currency appreciation, while lower rates compare to depreciation. Expected currency appreciation can lower yields on investments such as government bonds.
Step-by-step explanation:
According to the theory of Uncovered Interest Parity, the equilibrium exchange rate is that value at which the foreign and domestic rate of return are equal. This economic concept originates from the motivation for investment, which is to earn a return. If rates of return in one country are relatively high, that country will attract funds from abroad, while low returns encourage funds to flow out to other economies.
When interest rates rise in one country compared to another, like in the example of the United States and Mexico, more investors will demand the currency of the country with higher interest rates to take advantage of the higher returns. Consequently, the demand for that currency will increase and supply decrease, leading to currency appreciation. The opposite is true for lower interest rates compared to other countries, causing currency depreciation. The equilibrium exchange rate occurs where there is no incentive for investors to move funds between countries to take advantage of higher rates of return.
When considering expected exchange rate changes and interest rates, if a country's currency is expected to appreciate, the demand for that currency is likely to increase, which could lead to lower yields on investments like government bonds, as less incentive is needed to attract investment.