I am having problem with this. According to Forward exchange rate (FER) parity, offering higher domestic interest rate --> FER higher --> currency are expected to depreciate (direct quote D/F); On the other hand, higher interest rate --> higher return on investment --> financial account surplus -->excess demand --> currency will appreciate How should I explain this conflict? See the following problem South Africa’s tax revenue for last year was approximately $5 trillion while total spending by government was $9.5 trillion. This fiscal trend has been recurring for the past five years. In light of South Africa’s fiscal policy, they can expect to experience: A. higher interest rates leading to currency appreciation and smaller trade deficits. B. higher interest rates leading to currency depreciation and larger trade deficits C. higher interest rates leading to currency appreciation and larger trade deficits D. lower interest rates leading to currency depreciation and larger trade deficits.
C?
is it C ?? Tax Revenue collected is lower than the Govt Spending causing large trade deficit (each year) , so government begins to borrow, driving the interest rate up and hence the currency… - Dinesh S
C Also Higher interest rates -> currency appreciates -> Exports become costly -> another cause for a Larger trade Deficit.
This question just made me realize how much I truly detest Economics. UGH!
Dinesh S: what about According to Forward exchange rate (FER) parity, offering higher domestic interest rate --> FER higher --> currency are expected to DEPRECIATE (direct quote D/F); On the other hand, higher interest rate --> higher return on investment --> financial account surplus -->excess demand --> currency will APPRECIATE? How should I explain this conflict? why result from forward exchange rate parity conflict with the law of demand and supply ?
I’m in the weeds on this one too…
I suck at econ especially the Global econ and it has been a while since I got back to it, so hopefully I am not making a fool of myself. (1 + Domestic IR) = (F/S) (1 + Foreign IR) So increase in Domestic IR could be compensated by decreased S or increased F. Since inc in domestic IR is due to increased borrowing, S will decrease Since the deficit (increase in IR) is persistent, decrease in S will be persistent and not reverse, so the F will not increase. However, if high IR were due to higher inflation or something, I think I would expect the F would increase as opposed to the S decreasing.
I think your confusion here is with Forward Rate and Spot Rate? Basically what I think you’re saying is if interest rates increase: -Forward Rate depreciates -Spot Rate appreciates Those don’t conflict. If interest rates for the country A increase, foreigners will invest their money in the country A. To do this they need to buy currency A (increase in demand for currency A). At the same time, these foreign investors would want to cash out at some time, say 1 year, so in order to hedge their risk, they would arrange a short position on a forward contract on currency A (to sell currency A and buy their home currency). So the expectation of currency A in one years time, is that there will be an increase in supply of currency A, hence, the forward rate depreciates.
I think I get most part of what I said. Here is my understanding. Forward exchange rate (FER) will impose an anticipated downward (upward) pressure on the future Spot exchange rate (SER), but not quite impact current SER that much. So when examing the changes of current SER, we need to assume that the FER in short-run is fixed if using the S-F parity relationship right? In that sense, demand and supply of currency (changes in a country’s current account and financial account), income and the real interest rate will play more important roles than FER on current SER. Please correct me if I am wrong.
Ill go with C just based on intuition which is as follows: Gov spending more than they are getting back in tax revenue-> Demand for money is high ->money cost more-> interest rates go up. interest rates go up-> foreign demand for dollars go up due to increase in interest rates-> dollar appreciates. dollar appreciates->domestic goods are more expensive now relative to foreign goods ->export less domestic produced goods-> trade deficit widens. Just goin with my gut. all those formulas confuse me.
naivejoe Wrote: ------------------------------------------------------- > I think I get most part of what I said. > > Here is my understanding. > > Forward exchange rate (FER) will impose an > anticipated downward (upward) pressure on the > future Spot exchange rate (SER), but not quite > impact current SER that much. > > So when examing the changes of current SER, we > need to assume that the FER in short-run is fixed > if using the S-F parity relationship right? > > In that sense, demand and supply of currency > (changes in a country’s current account and > financial account), income and the real interest > rate will play more important roles than FER on > current SER. > > Please correct me if I am wrong. Sounds right to me. Just think of the parity relationship as holding between “Spot Rate at time 0” and “e.g One Year Forward Rate at time 0”.
Doesn’t sound right to me. The forward exchange rate doesn’t put pressure on the spot exchange rate. The forward exchange rate is a function of the spot exchange rate and a couple of nearly risk free interest rates.