Monetary policy and exchange rate

CFA Level II Economics
#1

Hi All,

Im a bit confused about the macroeconomic relationship between interest rate and exchange rate.

My question is, what is the impact of monetary policy to exchange rate ?

For example, by making the assumption of free flow of capital and floating exchange rate regime,

When a central bank carry out expansionary monetary policy, most likely lower real interest rate and higher inflation will result.

So under interest rate parity, it says the lower the interest rate relative to another country, the currency value will appreciate in long run.

But if we think in the angle of capital flow, when the country interest rate become lower, it will become less attractive to foreign investor which will lead to depreciation of currency value.

It seems to me the result is uncertain. But under Mundell Fleming Model, it says expansionary monetary policy will lead to depreciation… Did I miss out any assumptions behind different theory and model ?

Many thanks for your help

#2

Interest rate parity isn’t a force that drives exchange rates; its sole purpose is to prevent arbitrage.

#3

It seems I get what you mean. So may I know my below claim is valid ?

Those Interest rate parity (No matter it is covered or uncovered) or even PPP just describing the outcome, but it did not explain the force behind that change in interest rate. So what you mean the force that drives exchange rate is factors like net import, capital flow which suggest by Mundell Fleming model or other models.