I am trying to put this all together. With uncovered interest rate parity, which has no economic reason to hold in real life and for the most part doesn’t, currency exchange rates are determined by differences in nominal interest rates. The currencies with higher nominal interest rates will be expected to decline and the currencies with the lower nominal interest rates would be expected to appreciate. However with carry trades, a trader is able to take advantage of uncovered IRP not holding by buying the high interest rate currency and borrowing in the lower interest rate currency. With carry trades, the currency with the higher nominal interest rate could appreciate given hot money flows and investors seeking to take advantage of the carry trade. In this case the investor would want to invest in the higher nominal interest rate currency… Then moving to the currency management section, on page 377 in book 3 it states that inflation in NZD is expected to increase. The answer to question 2 on that same page states that the JPY/NZD exchange rate would be expected to decline if inflation is expected to increase in NZD. What I am not understanding is why you would not expect NZD to appreciate in value, not depreciate, due to investors trying to take advantage of the carry trade? Wouldn’t a higher inflation rate mean that nominal rates in NZD would be higher, so investors could earn a wider spread on the carry? Why would the investor expect NZD to depreciate and what is the difference between this example and the carry trade examples where investors flock to currencies with higher nominal rates for the spreads?
I think the answer to your question has to do with PPP. According to PPP, the currency with higher inflation will expect a depreciation in its currency and this holds in the long run. Carry trade happens because UIRP doesn’t hold. Yes, if there’s an increase in nominal interest rates, it’ll attract foreign capital and yes, an increase in exchange rate (in the short run). However PPP does hold in the long run, correct? This means that the exchange rate will overshoot and eventually the currency will depreciate. That’s why NZD depreciates.
I’d say a good rule of thumb is if the question mentions that it’s an increase/decrease in inflation, default to PPP and know that’s going to be a depr/appr of base currency and if the question leans you towards tightening/accommodative policy (or straight up mentions increase/decrease in real or nominal rates), it will be more of a short term response which would be appr/depr of base currency which is more of a short term view re: hot money flows leading to a appr/depr of the currency.
I hope this clarifies
It does, appreciate you taking the time to put together a response. Thank you!!