Question

Briefly explain the relationship between inflation, interest rates and exchange rates.

Answer 1

As per Purchasing Power Parity whichever country has a lower rate of inflation, the currency of that country should appreciate. In real life it has been found that inflation is one of the most important factor influencing exchange rates.

As per International Fisher effect the real interest rate across the globe should be same. The currencies with higher interest rates will depreciate because higher interest rate reflects higher inflation.

Rate of Inflation in a country has significant impact on the currency and exchange rates, If a country has a high inflation then currency value and exchange rates would be adversly affected.

Interest rate and Inflation are closely related and thus it affects exchange rates. When interest rates in a country would be lower then people will save less and spend more.This will lead to economic growth and currency value of the country would increase. But forgein investors may find this situation as Unfavourable as their investments would fetch lower returns.

However if a country's interest rate is high then foreign investors would like to invest their money and get higher returns and this in turn would strengthen the currency value of the Country.