Federal funds rate vs interest rate vs inflation rate

Hi everybody,

I got confused when calculating exchange rate for two currencies using inflation rate or interest rate. For example, if at Year 1, the EURO/USD exchange rate is 1:1.2 and if the EURO and USD inflation rates are 5% and 10%, the 1-year forward exchange rate will be (1*105%):(1.2*110%) = 1.05:1.32. That is, the USD is depreciated since its inflation rate is higher.

However, I saw a solution to a question saying that a decrease in U.S. target Federal funds rate will result in depreciation of USD. I can only understand this via common sense: if rate is low, you cannot earn much by holding USD, so to hold USD is less “attractive”, leading to a decreased demand for buying USD and thus increased demand for foreign currencies. Currency exchange is a market just like commodity markets and this change in supply-demand relationship leads to depreciation in USD. However, if I take the Federal funds rate as inflation rate and use the formula in the first paragraph, the conclusion will be the opposite. Why?

Thanks

Interest rate parity is not the only force that affects exchange rates. General supply and demand does as well, and it tends to work in the opposite direction of interest rate parity.