I’m having a really hard time reconciling the effects that interest rates and inflation have on exchange rates.
Suppose we have Currency A, Currency B, and exchange rate A/B. Under what circumstances will the exchange rate depreciate?
- inflation differential narrows
- nominal interest rate differential narrows
- currency A’s long-term equilibrium is revised upward
I understand that, if B’s interest rate rises (differential narrows), demand for its currency will increase, which would place upward pressure on its currency, causing it to appreciate relative to A. Would this scenario be different if the real interest rate differential narrowed?
However, I’m totally lost when it comes to the effect of the inflation rate differential. I know that B would depreciate relative to A under PPP, but that’s not right, apparently. Moreover, I have no idea what the third choice even means. Help?