Question

suppose a country has a combination of rising nominal interest rate and depreciated currency. This phenomenon appears to be inconsistent with the theoretical view that suggests a positive correlation between rising nominal interest rates and currency appreciation. How would you explain this apparent "contradiction" in the observed phenomenon? (Please use Fisher Effect)

Answer 1

• Usually, there is positive relationship between the nominal interest rate and appreciation of currency. Higher nominal interest rate implies the higher rate of return on investment. Thus, there is inflow of foreign investment in search of higher return. Which eventually, causes the appreciation of domestic currency.
• But it is not always true that high nominal interest rate will increase value of domestic currency, other factors also play critical role in this process. Fisher effect shows that how rise in inflation rate causes fall in real interest rate. Hence, when there is rise in nominal interest rate but side by side inflation also moves upward, the real return will fall. Thus, it will not be profitable to foreign capital to enter the market. Even it might cause outflow of currency. Thus, it does prove the positive relationship between nominal interest rate and appreciation of currency otherwise.