I am extremely confused as to the relationship between exchange rate and interest rate. In the covered interest rate parity equation we see that F(A/B) will be at a discount to Spot (A/B) if the interest rate of B currency is higher than A currency. So currency of a country depreciates if interest rate of country is higher than the other country.
Then in Mundell-Fleming it says that expansionary monetary policy of a country (thus low interest rate) leads to depreciation of its currency. Isn’t it contradictory to the covered interest rate parity equation?
The real exchange rate (A/B) is also positively related to the real interest rate of the country (country of B currency).
All the above concepts is making me confused about the relationship between currency exchange rate and interest rate of its country.
Could anyone please help clear the confusion?
Many things influence exchange rates; some pull them one way, some pull them the other way.
It shouldn’t be confusing.
(By the way, covered interest rate parity doesn’t say anything about whether one currency will appreciate or depreciate vis à vis another currency. All it says is that if forward contracts are priced at any value other than the CIRP value, there will be an arbitrage opportunity.)
Let’s see the CIRP in a context.
1.13=€1 i=5% i€=6%
F(/€)=(1.13/1)[(1+i)/(1+i€)] So F=$1.12/1€ The observation here is that given higher interest rates in Europe, you will need less Dollars to buy one Euro. Thus the base currency apparently depreciated. But wait. Imagine ECB now follows an expansionary monetary policy and interest rates fall to 5%. Mundell-Fleming predicts Euro depreciation because of falling demand for Euro. So what happens to the CIRP model? Nothing! Forward exchange will be equal to spot exchange rate, i.e. 1.13. The whole argument collapses. While this demonstrates how the two models can coexist without contradicting each other I am not sure it clears your mind. Or my mind, for that matter. I am still more inclined to tossing a coin when it comes to currency movements …
Thanks a lot for the answer!
I understand the concept of covered interest rate parity better now.
In my question I should have put the UIP (uncovered interest rate parity) because UIP says that the expected future spot exchange rate of a country’s currency will be lower if the interest rate is higher than the other country. This is where my confusion lies when compared with the relationship of exchange rate with monetary policy (monetary policy expansionary (lower interest rate)---->currency depreciation).
What would expalin that?