Question

6. Inflation, interest rates, and exchange rates

Relative inflation rates affect interest rates, exchange rates, the overall economic health of a country, and the operations and profitability of multinational companies.

Consider the following statement:

Countries with lower inflation rates will have lower interest rates.

Based on your understanding of the relationship between relative inflation rates and exchange rates, identify whether the preceding statement is valid or invalid.

The statement is valid, because the nominal interest rate is the sum of the real interest rate plus inflation, so lower inflation rates would result in lower interest rates.

The statement is invalid, because the nominal interest rate is independent of the inflation rate.

If companies borrow from countries with low interest rates, the potential gains from the interest savings will likely be _(offset/multiplied)_ by the losses from currency appreciation.

The currency of a country with a lower inflation rate than the U.S. inflation rate will __(depreciate/appreciate)____ over time against the dollar.

Answer 1

As nominal rate inclues the real interest rate and inflation, the following statement is true-

The statement is valid, because the nominal interest rate is the sum of the real interest rate plus inflation, so lower inflation rates would result in lower interest rates.

If companies borrow from countries with low interest rates, the potential gains from the interest savings will likely be offset by the losses from currency appreciation.

It is said that an investor should notbenefit from any potential gain from investing in any country. Hence, the two are offset.

The currency of a country with a lower inflation rate than the U.S. inflation rate will depreciate over time against the dollar.

One of the reasons for this is as investors take their money out of the country where interest rates are low which will result in depreciation of the currency.

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