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