Uncovered IR Parity and Relative PPP.

[archived_user]

I find the comparison between these Uncovered IR Parity and Relative PPP.
Let me elaborate through the following example.
US Interest Rate: 8%
EUR Interest Rate: 6%
According to IR Parity the dollar will depreciate by 2% relative to the Euro.
And then we if look at the same currencies:
US Expected Inflation Rate: 8%
EUR Expected Inflation Rate: 6%
According to Relative PPP the dollar will depreciate 2% relative to the Euro.
What I find confusing here is that a higher interest rate compared with a higher inflation will have the same relative effect on a currency? I have always thought a high interest rate will result in currency appreciation and a high inflation will result in currency depreciation.
What have I misunderstood and/or are missing here? Thanks for the help.

 

[archived_user]

Thammer wrote: .
What I find confusing here is that a higher interest rate compared with a higher inflation will have the same relative effect on a currency? I have always thought a high interest rate will result in currency appreciation and a high inflation will result in currency depreciation.
What have I misunderstood and/or are missing here? Thanks for the help.

There are many forces that affect exchange rates. Interest rate parity is one such force; it’s a weak force. There’s supply/demand; it’s a strong force, and it works in the opposite direction of interest rate parity.

 

[archived_user]

S2000magician wrote:

Thammer wrote: .
What I find confusing here is that a higher interest rate compared with a higher inflation will have the same relative effect on a currency? I have always thought a high interest rate will result in currency appreciation and a high inflation will result in currency depreciation.
What have I misunderstood and/or are missing here? Thanks for the help.

There are many forces that affect exchange rates. Interest rate parity is one such force; it’s a weak force. There’s supply/demand; it’s a strong force, and it works in the opposite direction of interest rate parity.

Thank you for your reply, much appreciated. I understand the point about supply/demand, which we have seen in effect in real life in the UK since the Brexit vote. However, that inflation and interest rates will have the same effect on the currency I find very confusing. What is the rational behind that? High Interest rates causes more demand for the currency (makes sense to me), and also a high inflation increases the likelihood of interest rate hikes which then again is likely to increase demand for the currency (this makes less sense, since you could argue that IR being low are the reason to the inflation, and the low IR reduces the demand for the currency)?
I appreciate your help and hope that my way of thinking described below helps to highlight where I might go wrong here.

 

[archived_user]

Thammer wrote:

S2000magician wrote:

Thammer wrote: .
What I find confusing here is that a higher interest rate compared with a higher inflation will have the same relative effect on a currency? I have always thought a high interest rate will result in currency appreciation and a high inflation will result in currency depreciation.
What have I misunderstood and/or are missing here? Thanks for the help.

There are many forces that affect exchange rates. Interest rate parity is one such force; it’s a weak force. There’s supply/demand; it’s a strong force, and it works in the opposite direction of interest rate parity.

Thank you for your reply, much appreciated. I understand the point about supply/demand, which we have seen in effect in real life in the UK since the Brexit vote. However, that inflation and interest rates will have the same effect on the currency I find very confusing. What is the rational behind that? High Interest rates causes more demand for the currency (makes sense to me), and also a high inflation increases the likelihood of interest rate hikes which then again is likely to increase demand for the currency (this makes less sense, since you could argue that IR being low are the reason to the inflation, and the low IR reduces the demand for the currency)?
I appreciate your help and hope that my way of thinking described below helps to highlight where I might go wrong here.

Don’t forget the trade balance. When a currency suffers inflation, the prices of goods and services increase (in that currency), so in the eyes of a foreign retailer or producer, it is relatively more advantageous to sell that product in the market of higher inflation.
Let’s take an example:
Country A, with currency A, with 25% inflation
Country B, with currency B, with 2% inflation
Country B producers see that the price of a certain good in country A is higher than in country B after adjusting for the spot exchange rate, so selling that good in country A is more advantageous. They start exporting to country A. The transaction requires that country A buyers pay with currency B making currency A to depreciate. More depreciated currency A equates the difference in prices seen at the beginning.
Hope this helps!

 

[archived_user]

Harrogath wrote:

Thammer wrote:

S2000magician wrote:

Thammer wrote: .
What I find confusing here is that a higher interest rate compared with a higher inflation will have the same relative effect on a currency? I have always thought a high interest rate will result in currency appreciation and a high inflation will result in currency depreciation.
What have I misunderstood and/or are missing here? Thanks for the help.

There are many forces that affect exchange rates. Interest rate parity is one such force; it’s a weak force. There’s supply/demand; it’s a strong force, and it works in the opposite direction of interest rate parity.

Thank you for your reply, much appreciated. I understand the point about supply/demand, which we have seen in effect in real life in the UK since the Brexit vote. However, that inflation and interest rates will have the same effect on the currency I find very confusing. What is the rational behind that? High Interest rates causes more demand for the currency (makes sense to me), and also a high inflation increases the likelihood of interest rate hikes which then again is likely to increase demand for the currency (this makes less sense, since you could argue that IR being low are the reason to the inflation, and the low IR reduces the demand for the currency)?
I appreciate your help and hope that my way of thinking described below helps to highlight where I might go wrong here.

Don’t forget the trade balance. When a currency suffers inflation, the prices of goods and services increase (in that currency), so in the eyes of a foreign retailer or producer, it is relatively more advantageous to sell that product in the market of higher inflation.
Let’s take an example:
Country A, with currency A, with 25% inflation
Country B, with currency B, with 2% inflation
Country B producers see that the price of a certain good in country A is higher than in country B after adjusting for the spot exchange rate, so selling that good in country A is more advantageous. They start exporting to country A. The transaction requires that country A buyers pay with currency B making currency A to depreciate. More depreciated currency A equates the difference in prices seen at the beginning.
Hope this helps!

Thank you much for your reply. That is very helpful, but this is also the part that I can understand. A higher inflation causes the currency to depreciate. What I do not understand is how according to uncovered IR parity higher interest rate will have the same effect? - in my mind a higher IR should increase demand for the currency and make it appreciate further. What is it that I do not get here? Once again thank you.