Referring to CFAI Volume 3 p128. In the answer to Q18, can you please explain the logic of why Canada with the lower expected inflation will lead to a stronger currency? I thought: Lower Canadian expected inflation LEADS TO Lower Canadian interest rates WHICH LEADS TO Lower demand for that Canadian Dollars WHICH LEADS TO Canadian Dollar DEPRECIATING (rather than getting STRONGER) Why is my train of thought wrong? Please enlighten - thanks!
You’re confusing NOMINAL interest rates with REAL interest rates. Inflation affects nominal interest rates. Low inflation expectations lead to lower nominal interest rates. Demand for CAD is driven by real interest rates. Higher inflation, by it’s very definition, means that your CAD will be worth less time t+1. When a currency is worth less relative to other world currencies, it has depreciated. If inflation is low relative to other countries, that means that the OTHER currencies with higher inflation will be worth less. Hence the home currency appreciates (stronger).
Thank you thank you - this is so much clearer now.
I’ve received advice from a CFA Charterholder that Currencies will appreciate/depreciate according to Real rates (in the short term) and Nominal rates (in the longer term e.g. 1 year in Q18, P128, Volume 3 of CFAI text). As such: - When there is Low Canadian Inflation, this leads to - Higher Canadian REAL RATE (assuming Canadian Nominal Rates stay constant), which leads to - Canadian Dollar Currency Appreciation IN THE SHORT TERM (but not in 1 year per what the Q is referring to) - When there is Low Canadian Inflation, this leads to - Lower Canadian NOMINAL RATE - Canadian Dollar Currency Depreciation IN THE SHORT TERM - Canadian Dollar Currency Appreciate IN THE LONG TERM (i.e. over time in 1 year per what the Q is referring to) Can readers please indicate agreement or disagreement (and provide reasons). Thanks for your clarification!
bidder Wrote: ------------------------------------------------------- > I’ve received advice from a CFA Charterholder that > Currencies will appreciate/depreciate according to > Real rates (in the short term) and Nominal rates > (in the longer term e.g. 1 year in Q18, P128, > Volume 3 of CFAI text). As such: > > - When there is Low Canadian Inflation, this leads > to > - Higher Canadian REAL RATE (assuming Canadian > Nominal Rates stay constant), which leads to > - Canadian Dollar Currency Appreciation IN THE > SHORT TERM (but not in 1 year per what the Q is > referring to) > > - When there is Low Canadian Inflation, this leads > to > - Lower Canadian NOMINAL RATE > - Canadian Dollar Currency Depreciation IN THE > SHORT TERM > - Canadian Dollar Currency Appreciate IN THE LONG > TERM (i.e. over time in 1 year per what the Q is > referring to) > > Can readers please indicate agreement or > disagreement (and provide reasons). Thanks for > your clarification! Think you are confused with a lot of things. Here is what I understand. For LT, the PPP normally holds, i.e., - real interest rate is equal for all countries and - differences in nominal rates are due to inflation ONLY. - changes in exchange rates are due to change in inflation ST, the PPP does not hold necessarily, which also means - real interest rate is NOT necessarily equal for all countries and - differences in nominal interest rates are due to difference in inflation and in real interest rates. - changes in exchange rates are due to change in inflation AND changes in real interest rates AND a lot of other factors (capital flow, economic strength, savings- investment imbalances,…) so looking individually, if Canada has lower inflation --> its currency is expected to appreciate (assuming that the real rates remains same and a host of other things mentioned above). In fact, the real rates change is not much 5.1% to 4.8% in favor of UK which will pull down this appreciation a bit.
Elcfa, To clarify, I’m only referring to the TOP LINE of Q18 i.e. Expected Inflation over next year being 2% fo Canada and 3% for UK Solutions say Canada’s currency should be stronger. Can you please explain the logic as to why Canada’s currency should be stronger? Thanks!
bidder Wrote: ------------------------------------------------------- > Elcfa, > > > Can you please explain the logic as to why > Canada’s currency should be stronger? Thanks! I think McLeod81’s explanation is quite clear. ‘Higher inflation, by it’s very definition, means that your CAD will be worth less time t+1. When a currency is worth less relative to other world currencies, it has depreciated. If inflation is low relative to other countries, that means that the OTHER currencies with higher inflation will be worth less. Hence the home currency appreciates (stronger).’ In terms of applying the PPP’s equation (assuming it holds), you have change in CND dollars/UK Pounds = CND inflation - UK inflation = 2%-3% = - 1% --> fewer CND dollars needed to buy 1 UK pound --> CND expected to appreciate with 1% Hope it is clear