Effect of interest rates on currency

CFA Level II
#1

Hello All,

I am trying to understand the effect of increasing interest rates on a country’s currency. According to reading 18, an expansionary fiscal policy (increasing interest rate) increases demand on domestic currency and hence it will appreciate.

High real interest---- Currency appreciates

But the international Fisher relation says that increase in interest rate has a similar effect as increasing inflation.

High nominal interest – Currency depreciates

I find this hard to understand since real interest rates are proportional to nominal interest rates; how can they have opposing effects on currency valuation?

Thanks for your time,

P

#2

Fisher relation is just to maintain equilibrium in currency market vauations. Yes, it is true that when interest rates are increased, the country’s currency is expected to depreciate to maintain the equilibrium or arbitrage-free or whatever in the perfect world.

In case of expansionary fiscal policy, the real interest rate will increase. But the investor is tempted for high interest rates. He may not worry about the long-term convergence of interest rates and hopes that the real interest rates will contnue.

Pls correct me if I am wrong.