Hi,
Please advise if higher interest rates make currency weaker or stronger?
If we look at Covered Interest rate parity - currency with higher rate becomes weaker.
On the other hand, Real exchange rate (under PPP) makes currency stronger. The same under Mundell-Fleming model (restrictive monetary, high rate, currency appreciation)?
Could someone clearly explain how it should be:)?
Under Mundell-Flemming with K mobility, higher rates attract more investors in your country which appreciates the domestic currency. Without K mobility, higher rates reduce domestic demand and imports, so the trade balance improves and currency appreciates too.
The interest rate parities simply suggest that the differential between domestic rates and foreign rates indicate the direction the exchange rate will take. We use the mean-reverting concept here, if higher rates suggest stronger currency, it also means the currency is supposed to depreciate overtime in order to fall back on its mean-reverting level. It’s like in the portfolio approach of exchange rates, when the country becomes riskier due to large budget deficits, investors will require depreciation of currency in order to be able to make a future gain when the currency will appreciate to reach the mean-reverting level.
Interest rate parity is only one of the forces acting on currency exchange rates.