I find the comparison between these Uncovered IR Parity and Relative PPP.
Let me elaborate through the following example.
US Interest Rate: 8%
EUR Interest Rate: 6%
According to IR Parity the dollar will depreciate by 2% relative to the Euro.
And then we if look at the same currencies:
US Expected Inflation Rate: 8%
EUR Expected Inflation Rate: 6%
According to Relative PPP the dollar will depreciate 2% relative to the Euro.
What I find confusing here is that a higher interest rate compared with a higher inflation will have the same relative effect on a currency? I have always thought a high interest rate will result in currency appreciation and a high inflation will result in currency depreciation.
What have I misunderstood and/or are missing here? Thanks for the help.
There are many forces that affect exchange rates. Interest rate parity is one such force; it’s a weak force. There’s supply/demand; it’s a strong force, and it works in the opposite direction of interest rate parity.
Thank you for your reply, much appreciated. I understand the point about supply/demand, which we have seen in effect in real life in the UK since the Brexit vote. However, that inflation and interest rates will have the same effect on the currency I find very confusing. What is the rational behind that? High Interest rates causes more demand for the currency (makes sense to me), and also a high inflation increases the likelihood of interest rate hikes which then again is likely to increase demand for the currency (this makes less sense, since you could argue that IR being low are the reason to the inflation, and the low IR reduces the demand for the currency)?
I appreciate your help and hope that my way of thinking described below helps to highlight where I might go wrong here.
Don’t forget the trade balance. When a currency suffers inflation, the prices of goods and services increase (in that currency), so in the eyes of a foreign retailer or producer, it is relatively more advantageous to sell that product in the market of higher inflation.
Let’s take an example:
Country A, with currency A, with 25% inflation
Country B, with currency B, with 2% inflation
Country B producers see that the price of a certain good in country A is higher than in country B after adjusting for the spot exchange rate, so selling that good in country A is more advantageous. They start exporting to country A. The transaction requires that country A buyers pay with currency B making currency A to depreciate. More depreciated currency A equates the difference in prices seen at the beginning.
Thank you much for your reply. That is very helpful, but this is also the part that I can understand. A higher inflation causes the currency to depreciate. What I do not understand is how according to uncovered IR parity higher interest rate will have the same effect? - in my mind a higher IR should increase demand for the currency and make it appreciate further. What is it that I do not get here? Once again thank you.
Sorry for the delayed response. I had not much time these days.
There is a list of international parities, so uncovered interest parity is not sufficient to explain the whole behavior of exchange rates in the short to long term periods. The world economy is said to be a dynamically-stationary system, this means that the economic variables fluctuate to each other to carry the whole world market to a long-term path. In other words, the forces try to achieve equilibrium, when they are out of equilibrium they take the opposite way to avoid permanent deviation (for example, you will never see interest rates of 1480% and increasing, or a inflation rate of 250000% and increasing; eventually they will revert to a healthy amount, soon or late).
Uncovered interest parity starts from this same statement. If two currencies show an interest rate gap, then investors will try to take advantage from that gap, making the gap to disappear. The high-yield currency will decrease in value to make this opportunity no profitable anymore. However, what real world shows? Uncovered interest rate parity does not hold in the short and middle-term because the high-yield currency does not depreciate, at least not in the amount predicted by this parity. This is true because 40 or more forces act over exchange rates, that’s why ERs are unpredictable. Uncovered interest parity has showed to hold in the long-term, note that this is empirically true.
A theory that can explain why the high-yield currencies must depreciate over time is the following:
Assuming a healthy inflationary environment, a high nominal interest rate must be fed by a high real interest rate. A high real interest rate means that that economy is currently overheated (in a peak); so assuming business cycle theory to be true soon, that economy will slow down. By the time that economy fall back, interest rates will go down. Obviously this happens in the long-term (5 years, 10 years maybe), also the interest movements are not that much aggressive neither.
You have to keep in mind that not all academic theories hold true in real life. With globalization the markets have become a lot more interrelated and complex so it’s difficult for one to forecast the shifts in rates. From the material: "Most empirical studies find, however, that the key international parity conditions rarely hold in either the short or medium term. The exception is covered interest rate parity, which is the only one of the parity conditions that is enforced by an executable arbitrage relationship. There are often significant and persistent departures from purchasing power parity, uncovered interest rate parity, and real interest rate parity."
"As noted above, the various parity relationships may seem of little empirical significance when examined over short time horizons. However, studies show that over longer time periods there is a discernible interaction between nominal interest rates, exchange rates, and inflation rates across countries, such that the international parity conditions described here serve as an anchor for longer-term exchange rate movements."
Bear in mind, too, that interest rate parity does not attempt to predict future exchange rates. It merely explains what they have to be to prevent arbitrage. You may enter into a forward contract with an exchange rate consistent with interest rate parity, but the market doesn’t know that you did, and if it did know, it would have the good sense not to care.