Inflation makes no sense. I did a Masters in economics at Cambridge. Never have I heard of a theory where stable inflation could lead to a currency appreciation. Further, this does not fit with any of the CFAI four theories for predicting currency rates. The capital flows approach is what I believe could cause interest rates being more likely than inflation to cause an appreciation.
Thanks. I certainly do not have a masters in economics from cambridge. So please allow me summarize and make sure that I follow along. relative form of purchasing power parity: differences in inflation between two countries will be reflected in changes in the exchange rate between them. => the country with higher inflation will see their currency value decline. Stable inflation = > no impact capital flows approach: lower interest rates result in less capital flowing into a country in response to the lower real interest rates. This results in currency depreciation. real interest rate decrease = > deprec Therefore a declining real interest rate is least likely consistent with an expectation of continued currency appreciation.
slouiscar Wrote: ------------------------------------------------------- > Thanks. I certainly do not have a masters in > economics from cambridge. > > So please allow me summarize and make sure that I > follow along. > > relative form of purchasing power parity: > differences in inflation between two countries > will be reflected in changes in the exchange rate > between them. => the country with higher inflation > will see their currency value decline. > > Stable inflation = > no impact > > capital flows approach: lower interest rates > result in less capital flowing into a country in > response to the lower real interest rates. This > results in currency depreciation. > > real interest rate decrease = > deprec > > Therefore a declining real interest rate is > inconsistent with an expectation of continued > currency appreciation. No. Capital flows leads to an equity market boom (as the cost of borrowing falls) which in turn draws in Foreign Direct Investment and Equity related investments. This appears on the Financial A/C of the balance of payments (attracted by market conditions). Foreign investors need domestic currency to pay for this and this bids up the price of the domestic currency. PPP is a long run view of exchange rates. This won’t hold over a year. Stable inflation has no impact. Additionally, this is well explained at the end of reading 23. Have a look for yourself.
real interest rate decrease = > deprec > > Therefore a declining real interest rate is > inconsistent with an expectation of continued > currency appreciation. a 25 basis point change is not enough to cause such a change indicated in question the answer had to be inflation ******** This is ALL under the assumption that the question said LEAST likely to cause currency appreciation. We are still unsure about the “LEAST” part right? For all we know the question said “Most” likely to cause currency appreciation
IH8FSA Wrote: ------------------------------------------------------- > real interest rate decrease = > deprec > > > > Therefore a declining real interest rate is > > inconsistent with an expectation of continued > > currency appreciation. > > > a 25 basis point change is not enough to cause > such a change indicated in question > > > the answer had to be inflation > > > ******** This is ALL under the assumption that the > question said LEAST likely to cause currency > appreciation. We are still unsure about the > “LEAST” part right? > > For all we know the question said “Most” likely to > cause currency appreciation Let’s just agree to disagree. It’s all hot air now anyway. Why stable inflation is more likely to cause a currency appreciation than something that supportive of investment is beyond me. 25bp for companies that borrow in the 100s of millions is not peanuts. P.S It said least likey.
Thank you DK. I have had made this mistake with interpreting the capital flows approach previously. I always want to think it was LT capital flows and therefore it takes time before a rate decrease results in an equity market boom and resulting currency appreciation. In the ST the rate drop causes less demand for the currency since 1+rd/1+rf = F/S. **headache** I’ll check out reading 23 tonight.
slouiscar Wrote: ------------------------------------------------------- > Thank you DK. > > I have had made this mistake with interpreting the > capital flows approach previously. I always want > to think it was LT capital flows and therefore it > takes time before a rate decrease results in an > equity market boom and resulting currency > appreciation. In the ST the rate drop causes less > demand for the currency since 1+rd/1+rf = F/S. > **headache** I’ll check out reading 23 tonight. The covered interest rate parity equation above also depends on expected not actual inflation. Were the inflation numbers actual or expected?
In general, I would say last year 08 figures are actual while current year 09 figures are expected since at this stage actual inflation for the year is unknown.
Cool.
> IH8FSA Wrote: > > > the answer had to be inflation The Dark Knight Wrote: ------------------------------------------------------- > > Let’s just agree to disagree. It’s all hot air now > anyway. > > Why stable inflation is more likely to cause a > currency appreciation than something that > supportive of investment is beyond me. 25bp for > companies that borrow in the 100s of millions is > not peanuts. > > P.S It said least likey. I will read this tonight. My head is spinning so I will let you go and move on after this. Your have set the record straight in that the capital flows approach states that lower interest rates result in currency appreciation, and stable inflation is not a factor in apprec or deprec. I disagree with his reasoning but isn’t IH8FSA’s kind of agreeing with you? He is saying that inflation is least likely consistent with an expectation of future currency appreciation. …since lower interest rates do result in appreciation based on the capital flows approach …they are consistent with an expectation of continued appreciation and therefore not least likely…
Yeah soz must have misread. I agree with his conclusion.
Damn. I looked this up last night and that is when I came across the EOC question I quoted in my initial post in this thread. That reignited my whole Capital Flows Approach confusion. In the EOC, Canada had a lower real interest rate and based solely on that they conclude that UK currency is expected to strengthen & Can is expected to weaken. lower rate deprec currency. and here it turns out it is lower interest rates lead to apprec currency. F me.
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What about the savings - investment imbalances approach : lower (real) interest rates => less savings => more capital needed from abroad to finance domestic investments => appreciating currency This also supports inflation as the correct answer
so whats the final conclusion here guys…both sides seem to have a point…but am still unsure as to whether inteest rate or inflation is the answer???
Decreasing interest rates might lead to currency depreciation OR appreciation depending on the approach you use while stable inflation is LEAST likely to cause currency appreciation because no theory says that stable inflation should lead to currency appreciation. I think inflation is the correct anwser.
tev79 Wrote: ------------------------------------------------------- > Decreasing interest rates might lead to currency > depreciation OR appreciation depending on the > approach you use while stable inflation is LEAST > likely to cause currency appreciation because no > theory says that stable inflation should lead to > currency appreciation. I think inflation is the > correct anwser. Well… I hope you are right! But I must admit that some of the other guys almost convinced me of the opposite…