say we have country A and B.
iA=10%; iB=2%; Spot A/B=1.2
so according to interest rate parity, currency B will appreciate,
what if currency A is actually currently taking restrictive monetary policy(so that interest is high as 10%) and currency B is taking expansionary monetary policy?
then does A currency should appreciate, B depreciate? isn’t that a conflict?
I don’t konw where I go wrong here.
Thanks for your help.
anyone?
It depends. I assume you are takling about uncovered interest rate parity- in reality that does not hold in the short run, otherwise ‘carry trade’ would not be possible. So, even if country A persues restrictive monitary policy, its currency should appreciate due to ‘carry trades’. To prevent this, there has to be capital flow restrictions or interest rate has to be lowered to deter capital inflows .
This is how I look at this situation.
The interest rates specified are Nominal interst rates.
Nominal interst rate = Real Int. rate + Inflation.
Now, assuming real rates are the same in these countries, this implies that inflation rate is high in country A than in Country B. So currency of country A should depreciate relative to currency of country B.
Someone wrote in the other thread very wisely that in Eco many theories contradict each other. You should actually be told which one to use in a given question.
What you wrote there, says that according to uncovered interest rate parity currency B appreciates and according to Mundell-Fleming model B is depreciating. We cannot state which effect will be stronger, so you need to know which theory to follow when determinig exchange rate changes.