Schweser stats on p. 227 of book 4: Lower interest rates also usually result in a lower value of the domestic currency, which is though to increase exports. In addition to teh direction of interest rates being important, it is also the level of interest rates that is important. Shouldn’t lower rates decrease the value of the currency as per IRP? Should the first sentence read “lowering” instead of “lower”? Either way I don’t get it. No errata so I am sure I am missing something dumb.
I would say yes to lowering doesn’t irp say thought that lower interest rates will lead to appreciation in currency? the way I see it lowering leads to depreciation of currency, increased exports, increased need for currency which leads to appreciation of currency
This is one of those wonderful areas where Schweser and the “real world” dont appear to see eye to eye.
This crap has been the bain of my existence for 3 years. Actually, according to IRP lower domestic rates would mean a forward premium discount, or the foreign currency would decrease relative to domestic (i.e., domestic currency appreciates). However, according to econ chapter, higher real rates lead to higher currency values. In this case lower domestic real rate would lead to domestic currency depreciating. So why the discrepency? Is it because IRP is assuming higher rates are composed of inflation? Asked this many times to different people and still don’t get it…
IRP says higher interest rate country will see the currency depreciate while lower will appreciate (while schweser says lower rates will lower value of currency). They could be talking in an absolute sense while IRP is realtive to other countries or it may be that real rates are lower (as they do mention a central bank trying to spur econ activity by lowering rates). Maybe this is implying that real rates are lower due to lower than expected inflation and cutting rates?
ng30 Wrote: ------------------------------------------------------- > So why the discrepency? Is it because IRP is > assuming higher rates are composed of inflation? > Asked this many times to different people and > still don’t get it… Rate is composed of real risk free rate and an expected inflation premium. Real rates are all that matters. I think this is the fischer equation from level II.
So I guess I should just figure IRP is also including inflation and get on with my life…
I just reread my first post. It should have read: Shouldn’t lower rates INCREASE the value of the currency as per IRP? Should the first sentence read “lowering” instead of “lower”? Either way I don’t get it.
Are you talking abou the relative economic strength approach? The higher short term rates result in capital moving into the country as a result of which the currency strengthens (since the demand for dollar increases). However, the way I understood it, the influence on the e xchange rate is short term. It is only true till a certain level of the exchange rate. Past that level, you need to question whether the yield differential will be enough to make up for the eventual depreciation. (I think the logic there is when your currency appreciates past a certain point, imports increase, exports decrease and the currency will begin to depreciate). Any thoughts?
this has been discussed in one of the thread a couple of month ago, while I still don’t totally get it, here is the conclusion in IPR the interest we use is norminal interest in the econ part, the interest used in the real interest… That’s all i know and I accept them both
short rates impact currencies in (at least) 2 opposing ways: 1) short term capital flows --> the “hot money” effect - ie higher rates attract hot money --> forces currency up. Lower rates cause hot money to flee to find a better home --> forces currency down - this happens quickly - leading up to and at official rate cuts/hikes. 2) long term capital flows - lower rates stimulate the economy --> profitability rises --> equity prices rise --> attracts long term capital flows --> currency rises. IRP supports the long term capital flow effect --> lower rates lead to higher relative economic growth --> leads to greater productive investment + demand for capital --> appreciating currency. (IRP assumes total integration, assumes real risk free rates are the same everywhere, assumes differences in nominal rates are due to inflation differentials - a LOT of assumptions and takes a LOOOOONG time to work) these 2 main capital flow effects work together in opposite directions. Which one prevails depends on the weight of money in each cycle in each country. Hope we don’t get questions on this stuff - it’s so vague and ambiguous