# " Methods of Forecasting Exchange Rates" Question

1. Relative PPP - " Country with Higher Inflation will see their currency value decline" -This confuses me, because when I think of high inflation, I think of the country increasing interest rates to combat the inflation, and currency 101 has taught us all along that the country with the higher interest rates will attract capital and therfore boost the value of that countries currency… Soooo why is the above the opposite? I could freakin never get a good grasp of this stuff.

PPP works in longer run , not shorter run. The intution behind PPP is, real rates are constant. Higher inflation and higher rate balance out. If a country has higher real rate, then its currency will appreciate.

I find this confusing too. Countries with higher REAL rates will attract capital. It all goes back to the fischer stuff at level 2. If it is just inflation it should be offset by the exchange rate.

Higher real rates bring about capital inflows and currency appreciation. Higher nominal rates (w / steady real rates) correspond to higher inflation and currency depreciation. -Capital will flow into a country to take advantage of higher REAL rates, not higher nominal rates. Nobody will want to buy the currency of a country with high nominal interest rates if they are going to lose that rate advantage to inflation and currency depreciation.

The intution behind PPP is law of one price. Similar goods should cost same in different countries (once currencies are translated) assuming almost no transportation costs and free flow of goods. If a country A has higher inflation compared to country B, Its currency has to decline to make law of one price hold. For example: Assume 2\$ = 1 Pound. One Pair of socks costs 2\$ in USA and 1pound in GB After a year with following inflation USA inflation 10% , GB inflation 0% Next year same item costs 2.20 in usa and 1 pound in GB. So 2.2 = 1 Pound (if you consider siilar movement for the whole basket of goods). Hope this makes sense.

This topic confused me for a while, but something clicked a few months back. Here is my take: As soon as the information becomes available, you will see a sudden rise in the value of the exchange rate as investors flock to a higher yielding currency. Thus, your intuition and currency 101 are correct as far as the instantaneous reaction. However, in order for returns across borders to be equal, investors who missed out by one second will come in and buy the higher priced currency that is yielding a higher rate, but will see a forward price on the currency below its spot creating a loss on the currency holding. Therefore, yes, you will see a rise initially, but the rise is two things 1) initial reaction to higher rates 2) Rates rising so that everyone expects a depreciation to occur in order for the excess interest rate return to be evened out by a loss on the currency holding. It really boils down to an equilibrium of expected returns. ***This obviously assumes markets are somewhat efficient and correctly incorportate the new information into the rate***