Struggled with forecasting exchange rate - capital flows

Quite stuck with the capital flows method. I picked up two examples with a paradoxical situation which I would like to verify to make sure I understand them correctly.

Example 1 1. Falling short rates lead to a decrease in interest rate. Typically, a decrease in interest rates leads to capital outflow because yield is lower, therefore, the currency depreciates. 2. However, investors may see a decrease in interest rate as potentially able to stimulate the economy. Given the expectation, instead of outflow, there may be an inflow of capital leading to currency appreciation.

  1. Therefore, the impact on the exchange rate is ambiguous.

Am I correct with the explanation in example 1?

Example 2 (which I struggled with the example in CFAI textbook) - weak currency, hot inflation 1. Typically an economy with a weak currency and high inflation, the right thing to do is to raise the interest rates as it will strengthen the currency and manage downward the inflation. 2. However, higher rates may stop capital outflow (which I can understand) but why does it lead to lower exchange rate and higher inflation? Wouldn’t the higher rates encourage capital inflow and strengthen the currency although it may make the effect on inflation ambiguous given that more money will be printed to accommodate the inflow.

Where did you read the second example? Can you post the snippet from the book?

Thanks for the reply! It’s based on the following example:

Note that long-term capital flows may have the effect of reversing the usual relationship between short-term interest rates and the currency. This is explained by the fact that a cut in short-term rates would be expected to boost economic growth and the stock markets, thereby making long-term investments more attractive. In this environment, central banks face a dilemma. Whereas they might want to raise interest rates to respond to a weak currency that is threatening to stimulate the economy too much and boost inflation, the effect may actually be to push the currency lower. Hence, the effectiveness of monetary policy is much reduced.

This appeared to be a problem for the Eurozone at times during 2001. As the economy slowed, the ECB was reluctant to cut interest rates because of rising inflation and a weak currency. The inaction seemed to make the currency weaker. Similarly, the Fed’s aggressive cutting in the first half of 2001 pushed the dollar higher, which attracted capital and thus reduced the impact of lower interest rates in stimulating the economy.

(Institute 101)

Institute, CFA. 2019 CFA Program Curriculum Level III Volume 3. CFA Institute, 5/2018. VitalBook file.

“Whereas they might want to raise interest rates to respond to a weak currency that is threatening to stimulate the economy too much and boost inflation, the effect may actually be to push the currency lower.”

A weak currency can stimulate the domestic economy by increasing exports and cause inflation to rise.

To control inflation, the fed would increase rates (monetary policy). However, increasing rates would reduce economic activity, which could weaken the currency further and lead to even higher inflation (from exports). Hence, the effectiveness of monetary policy is reduced.

The point here is that under the capital flows approach, long-term capital flows has the potential to reverse the relationship between short term rates and currency.

I can follow on the export leading to inflation because of greater demand for domestic currency leading to greater supply of domestic money (inflation).

But why would increasing rates weaken the currency or increases inflation? I am lost on that point. The conventional understanding is higher rates lead to more capital inflows since investors are after yield. Hence, wouldn’t it strengthen the currency? Although more capital inflows may lead to again more printing of money, hence increases inflation, right?

I think I have more or less gotten it already. The whole paradox is about expectations of investors versus what Fed is doing. Just to clarify one last thing in example 2 (weak currency, hot inflation), the market may perceive the increase in interest rate as constraining growth, so despite the better yield, capital outflow occurs which continues to weaken the exchange rate. But why would it lead to higher inflation give money supply has been decreased (from increasing the interest rate) and investors are exchanging domestic currency for foreign currency which further reduces the supply of money?

My reading from the text is if your currency is weak, foreigners are going to import more of your domestic product. They will exchange their currency for your currency, so people in your country will have more money to spend, thereby driving up inflation.

Look at the ECB example. The ECB was reluctant to cut rates because of rising inflation and weak currency. If they cut rates, currency will be weaker. This would stimulate the economy and potentially drive inflation even higher, so they are not really better off as you want to ideally balance growth and inflation, not trade one for the other.

Remember there are many theories on what drives exchange rates. You would have to look at the context as there’s many (opposing) forces at play. That’s the beauty of economics…

Actually, you are right. I think I got it. Thanks a lot for your help!