I have two somewhat related questions regarding currency appreciation/depreciation & monetary/fiscal policay that I was hoping someone could help explain or clarify
Page 160 of the Schweser notes volume3 states that increaes in the value of a currency are associated with currencies :
-with higher real or nominal interest rates
-with lower inflation relative to other currencies
This point is confusing me, if nominal interest rates are high is it possible that inflation is also high? Also, is there a way to close the loop with explansionary monteary policy, means decreasing interest rates and a lower currency value? Is that a correct statement.
Any clarification here would be helpful.
Currencies appreciate if:
-
Real interest rates are higher (should be risk-adjusted, but CFAI assumes they are all risk-free)
-
Nominal interest rates are higher/inflation is lower, these two are related, because nominal interest rates prices in expected inflation, while actual inflation may be lower due to:
i) The market assigned a value too high for expected inflation
ii) Inflation came out lower than expected
Closing the “loop” of higher inflation, higher nominal interest rates, and thus a stronger currency, isn’t the right relationship to consider, look at the above for better assesment. Expansionary policy lowers interest rates, and lowers the real interest rate component from the supply side. However, expansionary policy with high inflation would only lead to more inflation, and nominal interest rates wouuld shoot back up on higher expected inflation, nullfying the attempt to lower interest rates through the corridor rate. That’s one way to look at it.
When you refer to expansionary policy above, do those statements apply to both expansionary monetary and expansionary fiscal policy?
Expansionary fiscal policy tends to increase real interest rates and inflation, expansionary monetary policy tends to increase only inflation.
Expansionary monetary policy reduces real interest rates, all else equal, because money is cheaper, while expansionary fiscal policy increases real interest rates, because demand for money is higher, each applies a different force to the price of money. Monetary policy shifts the money supply, while fiscal policy shifts the demand for money.
To put in another way:
When real interest rates are higher and inflation is low > currency will attract demand from investors and appreciate This keeps going until expansionary monetary policy intervenes to lower interest rates and thus causing higher inflation > higher nominal interest rates > currency depreciation
It’s not that simple, traditional expansionary monetary policy depresses only short-term interest rates, the effects on inflation, long term interest rates, and hence currency demand is still subjective. Currency depreciation, when it happens, is not due to higher nominal interest rates on expansionary monetary policy, which actually tries to do the opposite.
But in general terms for the exam, expansionary monetary policy tends to pressure the currency downwards, but this has not been always the case in real life.
MrSmart - agree with you in a real life context. Tried to simplify the concept for exam purposes