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Can you please explain the effect of change in inflation & interest rates in one country over another country?
There is a question in Sept/Dec 16 past paper called [Herd Co Q19] which states:
Which of the following statements support the finance director’s belief that the euro [foreign currency] will depreciate against the dollar [local currency]?
1) The dollar inflation rate is greater than the euro inflation rate
2) The dollar interest rate is less than the euro interest rateNow, I’m stuck here!
If the dollar inflation rate is greater than the euro inflation rate, then if you use the purchasing power parity formula the exchange rate will be lower than the current €1.543 per $1. If the exchange rate is lower then $1 buys fewer €’s which means the € is appreciating (not depreciating).
The interest rate parity formula works in the same way as the purchasing power parity formula, and so using the same logic, if the dollar interest rate is lower than the euro interest rate then the exchange rate will be higher. A higher exchange rate means that $1 buys more €’s which means that the € is depreciating in value.
That means as the dollar inflation or interest rate increases, it will result in fewer Euros thus indicating appreciation of euros. right?
In case of a higher inflation rate in $
S1 = So x (1 + Foreign Inflation rate / Local Inflation rate)
S1 = Euro 1.543 x (1 + 3% / 1 + 5%)
S1 = Euro 1.513 (euro appreciate)
Euro appreciates because now there will be fewer Euros for $1In case of a lesser inflation rate in $
S1 = So x (1 + Foreign Inflation rate / Local Inflation rate)
S1 = Euro 1.543 x (1 + 3% / 1 + 2%)
S1 = Euro 1.558 (euro depreciate)
Euro depreciates because now there will be more Euros for $1Is that right, SIR? And the same goes with Interest?
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