Why does a decrease in domestic interest rates lead to an increase in the domestic currency? I guess i can see this from the interest parity equation, but logically, i thought it would be the other way around. Investments would decrease when the country lowers its interest rate causing a depreciation in their currency. I remember this being the case from economics on level 2.
Assuming IRP holds, real interest rates are the same in every country in the world.
So any difference in nomial interest rates is caused by inflation.
So the country that has the higher (nominal) interest rate has the higher inflation and will expect to see its currency depreciate.
There is also the argument that the central bank lowers domestic interest rates in an effort to help stimulate the economy, making local investment more attractive and thus triggering investment inflows. Since you need to buy the local currency to invest in that country, the exchange rate will tend to appreciate.
In the short run these investment inflows can cause the local currency to strengthen, whereas IRP is more of a longer-term effect.
and there is also the savings investment imbalance theory which states that if there is a savings deficit, a country will have its currency appreciate to account for the deficit.
it all depends on what they ask…theres no clear answer because different economists have different views.
there are 4 theories in one LOS somewhere in schweser books 2 or 3 which describe all this.
in THEORY, and CFA land… the forward markets will always adjust the currency to reflect interest rate differentials, so IRP forces the equation to hold because arbitrageurs would exploit any discrepancy as soon as it arose.
In practice, high interest rates often result in the carry-trade, with the currency in the high interest rate country appreciating. See the yen/dollar carry trade for many years, and currently Brazil is a prime example. They are levying financial taxes, cutting rates, and doing anything in their power to stop the Real from going through the roof.
capital outflows are short term effects of rate decreases . Longer term a lower interest rate is good for the economy in general and equities in particular. Capital can be induced to reverse the flow outwards when economic activty picks up.
However the Japanese experience has not been as smooth or fit teh above pattern. With low rates there was still an outflow that persisted for more than a decade.
This is not the US experience yet
The only reason that it is not happening in the US is because of our reserve currency status. Central banks are beginning to diversify out of the dollar, and if a new basket of currencies similar to the IMF’s SDR’s replaces the dollar as the reserve, you can bet the dollar is going in the toilet.