Currency Depreciation, Interest Rates, and Exchange Rate Dynamics
Currency Depreciation and Current Account Effects
Question: “Sometimes currency depreciation does not improve the current account balance in a country.” Is this true or false? Explain your answer.
TRUE.
Normally, when a country’s currency depreciates, its exports tend to increase, and imports tend to decrease. This happens because the country’s goods and services become relatively cheaper for foreigners, enhancing its attractiveness and competitiveness.
An increase in exports leads to an increased supply of foreign currency and an increased demand for the national currency. Conversely, a decrease in imports reduces the demand for foreign currency and the supply of the national currency.
However, the competitiveness of a good depends not only on its price but also on factors like quality and the demand elasticity of the good.
Therefore, it is true that currency depreciation might not always improve the current account balance. For instance, if consumer preferences shift away due to perceived quality issues, or if imports have highly inelastic demand (meaning demand doesn’t change much despite price changes), then exports might not increase as expected, or could even decrease. In such cases, the typical positive effects of depreciation on the current account may not materialize or could be significantly muted.
Interest Rate Hikes and Financial Capital Inflows
Question: “An increase in the interest rate in a country always brings financial capital inflows.” Is this true or false? Explain your answer.
FALSE.
Generally, when a country increases its interest rates, it can attract more financial capital inflows. Higher interest rates can offer higher returns on investments, making the country more attractive to foreign investors. This increased investment leads to fewer financial capital outflows and potentially more inflows.
This influx of capital typically increases demand for the national currency, causing the spot exchange rate to decrease (appreciation of the national currency and depreciation of foreign currencies).
However, while an interest rate increase can signal potential profitability, it’s not the only factor investors consider. The risk associated with investing in that country is crucial. If the higher interest rate is perceived as compensation for increased economic instability, political risk, or default risk, it may not attract inflows, or could even lead to outflows. Therefore, an increase in the interest rate does not guarantee an increase in net financial capital inflows.
Determinants of Spot and Forward Exchange Rates
Question: “Changes in spot and forward exchange rates are determined by the same variables.” Is this true or false? Explain your answer.
TRUE.
The spot exchange rate is influenced by several fundamental economic variables. The forward exchange rate, in turn, is closely linked to the current spot exchange rate and expectations about its future value, often incorporating interest rate differentials (as per Covered Interest Parity).
Therefore, we can conclude that spot and forward exchange rates are ultimately determined by the same set of underlying economic variables, although the mechanism and timing might differ.
Key variables influencing exchange rates include:
- Prices (Inflation): Higher domestic inflation tends to increase the spot exchange rate (depreciation), while higher foreign inflation tends to decrease it (appreciation).
- Expectations: Positive expectations about the domestic economy tend to decrease the spot exchange rate (appreciation), while positive expectations about foreign economies tend to increase it (depreciation).
- GDP (Economic Growth): Stronger domestic GDP growth can lead to increased imports and potentially increase the spot exchange rate (depreciation), while stronger foreign GDP growth can increase demand for domestic exports, potentially decreasing the spot exchange rate (appreciation). The net effect depends on various factors.
- Interest Rates: Higher domestic interest rates tend to attract capital and decrease the spot exchange rate (appreciation), while higher foreign interest rates tend to increase it (depreciation), holding other factors constant.
- Money Supply (M): An increase in the domestic money supply often leads to inflation and tends to increase the spot exchange rate (depreciation). An increase in the foreign money supply tends to decrease it (appreciation).
- Balance of Payments: Persistent current account deficits can put upward pressure on the spot exchange rate (depreciation), while surpluses can exert downward pressure (appreciation).
Forward Rate as a Future Spot Rate Predictor
Question: Explain how one can conclude that the forward exchange rate is an unbiased predictor of the future spot exchange rate.
The theory suggesting the forward exchange rate is an unbiased predictor of the future spot exchange rate relies on several key assumptions, primarily:
- Market Efficiency: The foreign exchange market is assumed to be efficient, meaning current prices (including forward rates) reflect all available information.
- Risk Neutrality (or Constant Risk Premium): Investors are assumed to be risk-neutral on average, or the risk premium required for holding foreign currency is zero or constant over time. If a risk premium exists and fluctuates, the forward rate will include this premium and won’t solely reflect expected future spot rates.
This concept stems from combining theories like the Uncovered Interest Parity (UIP) (related to the Fisher Open Relationship) and potentially aspects of Relative Purchasing Power Parity (PPP), although UIP is more direct.
Uncovered Interest Parity suggests that the expected change in the spot exchange rate should equal the interest rate differential between two countries. Simultaneously, Covered Interest Parity links the interest rate differential to the difference between the forward and spot exchange rates.
If we assume investors are risk-neutral and markets are efficient, arbitrage opportunities would theoretically be eliminated. In this idealized scenario, the forward premium or discount (the difference between the forward rate and the spot rate) would solely reflect the expected change in the spot rate needed to offset the interest rate differential. Thus, the forward rate (F) would equal the market’s expectation of the future spot rate (E[St+1]).
Mathematically, if the risk premium (rp) is zero:
F = E[St+1]
However, empirical evidence often shows that the forward rate is not a consistently unbiased or accurate predictor of the future spot rate, largely because the assumptions of constant risk premium and perfect market efficiency do not always hold in reality. Risk premia can vary significantly over time.