I know this has been discussed at least once before, someone please referesh me. In the first part of the Econ curriculum higher interest rates (domestic RFR lets say) serve to attract foreign investment in the domestic currency, thus appreciating it. However we know through Interest Rate Parity that this ultimately results in the domestic currency depreciating since it’s interest rate is higher relative to the foreign rate. Also in the first part in the curriclum it states that expectations about currency exchange movements result in supply/demand shifts, i.e. expected depreciation decreases demand and increasese supply. Given this i’m confused about how increase rates increases demand for currency, since ultimately it will depreciate and the expectation of this depreciation should have a net effect of kind of canceling eachother out (int rates up = currency up, but exp depr = currency down).
IRP assumes that real interest rates are constant. The higher interest rates referenced in your third paragraph are nominal rates. Given constant real rates and higher nominal rates the currency will depreciate due to higher inflation. Think of it like this: (i) increase in real rates means currency appreciates; and (ii) increase in nominal rates (with real rates constant) currency depreciates. Hope that helps Mike
It does help, I had a feeling the first portion of economics (rates up = currency appr) had to do with real rates, because thats logical, but it never clearly stated it, and often times neither do the questions when they ask. The format is usually such that: “An increase in interest rates cause _____ to happen to currency demand” – in this situation no differentiation between real and nominal rates is mentioned, and no statement on whether interest parity is in effect are mentioned either.
When they just say interest rates, I take it to mean nominal rates, because those are the rates that people talk about. The problem with the above analysis is that if the Fed increases the target Fed funds rate, and interest rates start to increase, it is not clear whether the currency will appreciate or depreciate, since no one knows whether real or nominal interest rates are the ones increasing! If you think it is nominal rates increasing, then currency depreciates…if the increase is in real rates, then expect currency to appreciate. Do you agree?
I agree, and again, my problem is not comprehending real versus nominal effects, it’s the fact that they often dont say the world “nominal” when asking the question, and also don’t mention that real rates are constant. IMO you need to know whats happening to the real rate, and if you are being given real or nominal, to make any assumptions. The only argument I can come up with is perhaps that in the earlier chapters parity is not being discussed, so maybe its assuming parity doesn’t hold and thats why inc int rates result in currency apprec?