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?