Economics – Exchange rates | e-Consult

Interest Rate Changes and Exchange Rates:

Short-run effects: An increase in interest rates in a country typically attracts foreign capital seeking higher returns. This increased demand for the country's currency leads to appreciation (the currency becomes more valuable). Conversely, a decrease in interest rates can lead to currency depreciation as investors move their capital elsewhere.

Long-run effects: In the long run, interest rate changes are more closely linked to PPP. If a country has higher interest rates, it tends to experience higher inflation. PPP suggests that exchange rates adjust to equalize the price of identical goods and services across countries. Higher inflation in a country with higher interest rates will lead to a depreciation of its currency to maintain PPP.

Relationship to Purchasing Power Parity (PPP):

PPP is a theory that states that exchange rates should adjust to equalize the purchasing power of currencies. The interest rate effect on exchange rates is often seen as a short-run deviation from PPP. If interest rates differ, PPP suggests that exchange rates should adjust to offset the difference in expected inflation. Therefore, changes in interest rates can influence exchange rates in the short run, but PPP provides a framework for understanding the long-run equilibrium exchange rate.