I am abit confused. Interest rate parity implies that if country A has higher interest rates, then it’s currency should depreciate relative to country B with the lower interest rates. But I don’t get it. Country A’s higher interest rate would attract more demand for its currencies since investors would want to move in and supply of country A’s currency would fall since country A’s investors would not supply so much of its own currency. This is straight from the determinants of supply in Book1. Which would raise the value of country A’s currency right? And not depreciate it as what interest rate parity suggests?
1.Some countries actively target exchange rates by practicing “leaning-against-the-wind” i.e. they try and reduce the effects of hot flows into their country by managing real rates . 2.In the case when Higher interst rates prevail , a country’s bond prices will fall and foreign investors will get hurt . This would have a stabilizing effect as they pull their holdings out again . Supply & Demand work both ways. Note that Higher nominal rates does not mean Higher real rates automatically . IRP only says that real rates should stay the same in the absence of currency exchange rate manipulation
I like to think of buying a currency when interest rates are higher than other countries, as a similar idea to buying a stock at the peak of an equity market bull run. The investment is more than likely overbought, so it is very likely to decrease to its true value over in the longer run. Knowing where we are in the cycle is very difficult because it involves making predictions about expected inflation. Many of the world’s best economists have trouble predicting inflation accurately. The generalization is that the lower interest rate currency will appreciate to a real value equal to the higher interest rate currency because of the inflation differential.