Open market sales of securities by a country’s Central Bank will most likely result in:
A. Decreasing short term interest rates
B. Appreciation of the domestic currency
C. An increasing growth rate of real GDP
Answer. B. Sale of secs reduce excess reserves in banking system causing short term interest rates go up. If the monetary transmission mechanism operates normally long term interest rates should also increase the domestic currency should appreciate and economic growth and inflation should decrease.
My question is if interest rates increase won’t a country’s currency depreciate compared to other currencies? Interest rate parity requires that the currency with higher interest rates will sell at a discount in the forward market.
The purpose of interest rate parity is not to predict future spot exchange rates; its purpose is to prevent arbitrage.
If someone can earn 2% risk-free on their currency or 5% risk-free on yours, which currency do you think they’ll prefer to own?
You are contradicting yourself. If a currency pays 3% more than another, everyone wants to invest there but do you think they will actually gain that 3% when they convert the currency back after their holding period? Doesn’t the parity hold IRL?
In India RF rate would be obviously greater than US fed rate but nobody says rupee is more valuable than dollar.
I’m pretty sure that I’m not.
Generally, no. At least not in the short run. That’s the basis for carry trade.
It’s not a matter of being more valuable or less valuable. It’s a matter of stability of exchange rates. If the INR/USD exchange rate is volatile, then investors may not be inclined to gamble on carry trade in those currencies. However, the greater the interest rate differential, the more likely that at least some investors will take the bait.
Thank you for your detailed explanation. I would take this as a new learning.
Didn’t think anyone would respond at all on my first day on analyst forum.
I can delete my comments and repost them tomorrow if that will help alleviate any cognitive dissonance you may experience.
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