Monetary Tightening Impact of Currency Forwards vs. Capital Flows

Page 418 - Book 3 EOC Questions

For Questions 20-23 in this section it has a case with an example on SEK/EUR exchange rates pertaining to Question 22. The case info states that due to Swedish monetary tightening, the SEK/EUR exchange rate is now trading at a forward premium.

So does this mean that monetary tightening will lead to higher nominal interest rates? I am confused by this, so with monetary tightening, we would expect inflation to decrease. This would lead to lower nominal rates. Why would SEK/EUR be trading at a premium if SEK is experiencing monetary tightening? Does monetary tightening = low expected inflation, higher nominal rates, or higher real rates?

In terms of monetary policy, loose monetary policy = high expected inflation. Does this mean nominal rates increase because of high expected inflation or nominal rates decrease because the central bank is targeting lower rates?

Assuming Covered Interest Rate Parity holds, the forward rate should be based on the difference in nominal interest rates between the foreign and domestic currency.

In this specific example, if SEK undergoes monetary tightening, nominal rates will rise relative to EUR, hence EUR trading at a forward premium.

In terms of inflation, tight monetary policy would likely lower future inflation and nominal rates, but I think related to this specific example we are only comparing vs another currency and not analyzing fiscal, yield curve, or business cycle. Therefore the logical answer is that tighter policy will raise nominal rates in comparison to EUR, with no other detail or assumptions.

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Covered interest rate parity always holds.


Typically, yes.

Unless the increase in the real rate is as much as or more than the decrease in inflation.

Which is what happens.