Interest rate parity suggest the country with higher real interest rates will see the value of its currency depreciate to force arbitrage free trade. However SS 6 CFAI page 102 says : ‘‘when interest rates are high When interest rates are high, inflows are likely to be higher and the currency value rises…However, the link between interest rates and the currency sometimes works the other way. This is because investors may see higher interest rates as slowing the economy. If a currency departs from the level that equilibrates trade for a long time, the resulting deficits or surpluses may eventually become too large for capital flows to finance.’’ Do higher interest rates in a country result in appreciation or depreciation of currency?
higher nominal depreciates Higher real appreciates correct?
1)The fisher international relation says real interest rates will be equal across borders in long term. So inflation differential = nominal interest rate differential. 2)CIRP always hold so Currency with higher nominal interest rate and higher inflation will depreciate. 3)But real interest rate could be different in short run due to real GDP growth . In this situation the currency with higher Real Interest rate will appreciate. 4)ALL differentials whether long term or short term based on inflation or interest rate are adjusted by exchange rates movements.
Relative Economic Strength forecasting: Focus on ST capital flow. Higher interest rate => capital moves into that country => currency appreciate. Capital flows forecasting approach: Focus on LT capital flows. LT capital flows may have the effect of reversing the usual relationship between short-term interest rates and the currency. Higher interest rate => Equity investment/ FDI falls => Demand for currency falls => currency depreciate Hope it helps.
thanks guys. Well summarized. It helps…
@B_C “Higher interest rate => Equity investment/ FDI falls => Demand for currency falls => currency depreciate” I think If higher interest rates, foregin investors are interested in investing into that country ==> FDI rises ==> high demand for currency … Am I wrong here ?
You are right for short run -> higher interest, foreign investor attract by higher interest -> higher demand for currency (predicted by Relative Economic Strength approach) But for Long run -> higher interest cost, higher required rate of return, stock price falls. FDI falls -> lower demand for currency (predicted by Capital flows forecasting approach).
That’s why Schweser says " The flow if LT fund complicated the relationship between ST rates and currency value. e.g. a cut in US ST rate may actually strength the dollar, because the cut night promote US growth and attractiveness of US stock. This makes the central banks’ job more difficult"
Thanks B_C. to summarise, in the short run higher int attracts FDI/foreign capital. In the Longrun, Higher interest is not beneficial for the currency. Thanks
I recall doing a question where the answer was that interest rates may or may not have an impact on the currency values. Anyone remember this at all? I think it was in schweser somewhere.