What equalizes any disparity in interest rates of two countries according to interest rate parity?

Interest rate parity is a fundamental concept in the foreign exchange markets that helps explain the relationship between interest rates in different countries and their respective currencies. The principle behind interest rate parity posits that the difference in interest rates between two countries will be offset by changes in the expected future exchange rates of their currencies.

When considering this principle, the movement in currency exchange rates serves as a mechanism that adjusts and equalizes any disparities in interest rates. If one country offers a higher interest rate compared to another, it attracts investors seeking better returns. This influx of capital leads to demand for the currency of the country with the higher interest rate, causing its currency to appreciate. Simultaneously, the currency of the country with the lower interest rate may depreciate as capital flows out. This adjustment in exchange rates aligns the returns on investments in the two currencies, thus neutralizing the advantage stemming from the differing interest rates.

In contrast, fixed exchange rates would not allow for the necessary adjustments in currency value to equalize interest rates. Similarly, while a higher demand for a stronger currency might influence exchange rates, it does not inherently provide a direct mechanism for balancing interest rates. Lastly, the balance of trade can impact exchange rates, but it is not the driving factor in equalizing