The higher the expected inflation rate in a country, the lower is the nominal interest rate in that country. If the real rate of interest is the same internationally, then the nominal interest rates differ by the expected inflation differential in two countries. The expected rate of return depends a. The U.S. dollar appreciates against the German mark if a. the U.S. interest rate falls. Today's forward rate will equal the future spot rate.
Central banks intervene in the foreign exchange market to smooth out currency fluctuations.
There is no limit for central banks intervention. In the case of an appreciating domestic currency, central banks often sell foreign currencies in exchange for domestic currency to stop the appreciation. According to the interest parity condition, if the domestic interest rate is a. above the foreign interest rate, then the foreign currency is expected to depreciate. If real interest rates are equal in the United States and Germany, and if the inflation rate in the United States is lower than that of Germany, a. the German mark should appreciate relative to the dollar.