I am thoroughly confused with the effect of real interest rate increase and inflation. I understand the increase in real interest rate increases capital inflows and hence causes appreciation of domestic currency. But inflation seems to have a negative effect- is it because the exchange rate falls as a result of increased inflation? I am so confused with this whole topic - am not even sure my question makes sense. Ok my question is why isnt the increase in real interest rate have the same impact on the nominal interest rate(which is what i assume all the equations are based on). I.e increase in real interest rate causes a fall in exchange rate as well.

Think of it in real terms. If inflations rises, real rates turn lower. Real interest rates falling causes domestic currencies to depreciate.

Thx but I am not sure i agree with this - helps me understand but not sure about the correctness of this. Anyone else have any inputs?

Nominal rates and real rates will have different effects on currency exchange rates. Notice that the Nominal rate is approx = real rate + Inflation. Therefore, countries with higher nomnial rates will also have higher inflation. Higher inflation means the domestic currency weakens compared to a country with low inflation. Why is that? because the domestic currency unit is now worth less (can buy less) than it could before the inflation increased. This is linked to the idea of interest rate parity. Investing in a country with higher nominal rates may seem to be a good idea, but in the end any gain in interest return will be offsett by the depreciating currency. The foreign currency will depreciate because it has a higher inflation rate. So for example, if England has 25% rates, you could invest in england. Your return would be 25% in nominal terms. So although you get 25% return in england, the pound will depreciate as compared to the US. When you convert your returns to the dollar, the additional yield in england will be offset by its currency depreciation. higher REAL rates however means that you can earn a higher return that will not be offset by any changes in exchange rates. So if England has higher Real rates, people will want to invest in England. This causes foreign demand of the pound to increase, which makes the pound appreciate. This gets a little more complicated with monetary and fiscal policy. Just remember - higher nominal rates or higher inflation in country A will cause the currency to depreciate relative to a country with lower inflation or lower nominal rates. Higher real rates in A causes the currency to appreciate vs a country with lower real rates.

piwanowi’s statement is only correct given that nominal rates are constant. It’s intuitive that if nominal rates stayed the same from yr t-1 to yr t, but inflation actually rose from yr t-1 to yr t, then real interest rates must have fallen since (1 + r real)(1 + inflation) = (1 + r nominal).

@spanishesk- I understand your point -its very logical. I am just finding it hard to prove it mathematically just to refer to my earlier posting the rate r that is used as interest rate- what rate is that- does the real interest have any impact on it, coz if it does as per the formula (1 + r real)(1 + inflation) = (1 + r nominal), then it really doesnt make sense then.

the r in interest rate parity is nominal return. /L \*(1+Nominal return )/(1+Nominal Return) = Forward $/L i think this idea also is that real rates accross borders are all equal (if they werent, then investors would flood the country with higher rates, setting them to equilibrium). So real rates are assumed to be equal accross countries, then differences in nominal yields are due to inflation. I think that makes sense.

Edited. Disregard.

why does it not make sense? suppose Ghana’s nominal int rate is 9.0% and the expected inflation rate is 3.5%. Real interest rate then is, (1.09) = (1+real int r)(1.035). Solve for real int r and get 5.3%. In other words, nominal interest rate should in theory be explained by inflation and real interest rate.

wbrocks, nominal = real + inf is the same thing as (1+nom) = (1+real)(1+inflation). The latter is actually the more precise measure, whereas the prior is an approximation.

wbrocks – thats a simplification of the actual formula

skwak88 Wrote: ------------------------------------------------------- > wbrocks, nominal = real + inf is the same thing as > (1+nom) = (1+real)(1+inflation). The latter is > actually the more precise measure, whereas the > prior is an approximation. Sorry, you’re right. I just remembered the Level 1 curriculum stating that the nominal rate could be calculated both ways, with just a slight difference. I edited the post as soon as I realized it. Wow, you guys were fast to jump on that.

The real interest rate does not adjust itself to inflation – its is the nominal interest rate that changes upon inflation. The real interest rate is based purely on demand supply factors skwak88 Wrote: ------------------------------------------------------- > why does it not make sense? > > suppose Ghana’s nominal int rate is 9.0% and the > expected inflation rate is 3.5%. > Real interest rate then is, (1.09) = (1+real int > r)(1.035). Solve for real int r and get 5.3%. In > other words, nominal interest rate should in > theory be explained by inflation and real interest > rate.