Effect of changing interest rates on exchange rate

[neiljeff123]

Evening All,
I’ve been struggling with a concept and wonder if anyone can shed some light:
Imagine the risk free rate in the UK is 2% and is 1% in the US. The rate in the UK then moves up to 3%. Which of the following would result:
1) The GBP appreciates compared to the USD as the rise in the UK risk free rate means the attactiveness of investing in the UK increases compared to the US on a relative basis
2) The GBP depreciates as the international fisher relation suggests an increase in the interest rate differential would cause the inflation differential to move in the same way. However, an increase in the inflation differential would lead to a depreciation of the currency whose inflation rate has increased on a relative basis.
Thanks in advance
p.s. I studied econ at uni so really should know this by now!

 

[naren]

Why did UK nominal rate go up?
If because real rate went up, then 1 is true
If because inflation then 2.
If both then undetermined.

 

[edupristine]

The ans will be 2)
2) The GBP depreciates as the international fisher relation suggests an increase in the interest rate differential would cause the inflation differential to move in the same way. However, an increase in the inflation differential would lead to a depreciation of the currency whose inflation rate has increased on a relative basis.

 

[libero28]

Naren_ - I liked that answer, thanks for that.
Edupristine - I’m not sure your answers to questions on this forum are correct a lot of the time. It may pay to express opinion as opposed to fact (in my opinion).

 

[kobi]

IRP states that GBP must depreciate by incremental 1% in order for the risk free returs across countries be the same.

 

[tjcfa]

Since it does not specifically state real, u assume nominal and answer #2 is correct.

 

[krazykanuck]

libero28 wrote:Edupristine - I’m not sure your answers to questions on this forum are correct a lot of the time. It may pay to express opinion as opposed to fact (in my opinion).

HAHA. It’s a good thing you qualified that as its your opinion.