Inflation/deflation vs currency appreciation/depreciation

[Jaskarn]

I wanted to ask that if inflation, a proxy for interest rate, increase then why currency depreciate?

My explanation: If inflation increases, the interest rate in that country will also increase. Due to the increase in interest rate, the foreign investor will invest in that country and demand for that country's currency will increase. Due to increase in demand currency should appreciate.

 

[David Harper CFA FRM]

Hi @Jaskarn Great question. We have members with more expertise than myself on macroeconomics for sure. So I just want to share a "textbook" perspective basically informed by the Saunders (Chapter 13, FRM Part 1, Topic 3 on foreign exchange). He explains two concepts: purchase parity (https://en.wikipedia.org/wiki/Purchasing_power_parity) and the FX manifestation of the no arbitrage cost of carry model in Hull, interest rate parity (see https://en.wikipedia.org/wiki/Interest_rate_parity). If we focus only on narrow first-order effects, then my interpretation is that both of these point in the same direction:

• PPP says higher inflation --> currency depreciation: "According to PPP, foreign currency exchange rates between two countries adjust to reflect changes in each country’s price levels (or inflation rates and, implicitly, interest rates) as consumers and importers switch their demands for goods from relatively high inflation (interest) rate countries to low inflation (interest) rate countries. Specifically, the PPP theorem states that the change in the exchange rate between two countries’ currencies is proportional to the difference in the inflation rates in the two countries." Per the simple formula, if (e.g.) the US inflation rate is higher (than foreign inflation rates), then its currency should depreciate as consumers/importers shift demand to lower inflation countries.
• IRP says higher interest rate --> currency depreciation: per the no arbitrage carry trade, if the US offers a higher interest rate, then the forward FX rate must imply depreciation of the US dollar versus the foreign currency. For example, if the US interest rate is 3.0% but the EUR rate is only 1.0%, then I will invest in EUR only if, at the end of the period, I can translate the slower-compounding EUR into more (relative) dollars, which is future dollar depreciation.

By first-order I mean, these are unrealistic conclusions because the add-on/feedback/second-order effects are not incorporated into supply/demand phenomena, so immediately I would add a few thoughts

• In interpreting these two narrow textbook models, I do not mean to disagree with your theory but rater add to it. From the macroeconomic perspective of balance of payments, your argument looks good; for example, here and here (in particular: "By reducing the money supply, the Fed raises interest rates, which are already increasing to keep up with accelerating inflation. The resulting inflationary premium added to interest rates attracts foreign savings seeking higher real rates of return ... As the money of foreign savings makes its way into U.S. financial markets through the capital account, the demand for dollars increases. The demand for dollars increases as foreign savers convert their currency into dollars in the international currency markets. The dollars are then used to purchase U.S. financial assets such as Treasury Bills, Notes and Bonds. Figure 13-3 shows the demand for dollars increasing from D$2 to D$3. As a result, the dollar appreciates in value."). Just as you've already said.
• The interest rate in IRP is the nominal rate = real rate + inflation rate; so there are complexities with using inflation as a proxy for (nominal) interest rates. Presumably there is a difference between rates that increase due to inflation (expectations?) versus increases in the real rate.
• Notice the PPP (it seems to me) explains the dynamics in terms of consumers (i.e., demand for goods) while the IRP is about investors (capital). So we have supply/demand curves in both capital market and goods markets. IRP refers to investor demand for currencies while PPP (i think) refers to goods and assets which happen to be denominated in currencies. So the dollar appreciates either because investors demand more dollars and/or consumers buy dollar-denominated goods/assets. I hope that's helpful, thanks for a thought-provoking question!