Hi guys, I’ve got a question regarding Interest Rate Parity and the related change in the value of a currency: In the study notes they say that if in one country has higher interest rates than another country, the currency of the country with the higher rates should depreciate (if IRP holds). For example: In Europe, i = 8% and in the US, i = 6%. If IRP holds we expect the euro to depreciate. This is counter intuitive to me. If the European interest rate is higher, I would expect the euro to appreciate because more ppl are going to put money in European bank accounts. This leads to more demand for the euro and hence appreciation. Can anyone help me on that? Thanks!!!
More Euro’s chasing same bonds/loans will raise interest rates , thus lowering prices of Bonds/loans in Euros . This will have a stabilizing effect , unless Euro governments simultaneously adopt growthy policies stimulating demand, in which case inflation would grow. Higher or lower fx rates are relative . If capital can flow freely , any temporary mispricing will be arb’d out eventually through PPP mechanism or excess capital flows “For example: In Europe, i = 8% and in the US, i = 6%. If IRP holds we expect the euro to depreciate” If Euro rates are higher , inflation is also likely to be higher in Euro nations and real rates are likely to be similar ( nominal rate excess will be balanced thru inflation rate excess ). Capital flows are likely to act as the grease to make parity machinery work smoothly
That gave me some pause too, but here’s why i think its right. In order for me to get 8% in Europe they have to be willing to borrow at that rate, but if i’m a bank or other big institution why would i borrow at 8% when I can borrow in US for only 6%? The only way people would still be willing to borrow at 8% is if they believe that euro currency will depreciate. i.e. yeah im paying more in interest from a rate standpoint, but i think the currency will depricate meaning i buy that currency to pay it back cheaper. in contrast, US may be a cheaper rate, but if i expect that IRP holds that currency will appreciate meaning i will have to pay more for dollars to pay back the loan.
the simple answer is that IRP uses nominal interest rates and assumes real interest rates are the same. thus, if i = 8% in europe and i = 6% in the US, the higher rate in europe is due to higher inflation, which we know depreciates a currency. higher real rates are what make ppl put more money into european bank accounts. the one bit of confusion is that there is one section in the econ reading where it actually says that it is an inc in NOMINAL int rates that lead ppl to want to demand a currency and thus have it appreciate. i asked this question on the forum awhile back and the reasoning i got was that demand is caused by several factors and nominal int rate is just one of them so you have to see what other factors are at play.
agreed with the show NY, that’s the clearest explanation, and was also my initial thought. Here it is with math though: starting with an investment of 100 USD, which I’ll put at 83 EUR for no particular reason. money invested return (1 yr) i = 8% EUR 83 EUR 89.64 EUR i =6% USA 100 USD 106 USD Beg of year exch S EUR/USD = .83 End of year exch S EUR/USD = .8457 The exchanges shown assume that interest parity holds true. You can see that although you, in nominal terms, got an 8% return on your Euros, and only a 6% return on your dollars, the real return was the same in both cases. At the end of the year, 106 USD was able to buy 89.64 Euros since over the course of the investment period, the Euro had depreciated in value relative to the USD (or the USD had appreciated in value relative to the Euro, or some combination of the two, whatever). That being said, as an investor, you don’t care whether you get a nominal 8% return in Europe or a nominal 6% return in the USA, because the real return will be the same in both cases. Inflation in the country with the higher interest rates being offered is the tool that makes the real return equivalent across nations (ie it is what makes interest rate parity possible between countries that offer different nominal rates, all risk being equal). Hope that answered the question right : )