I am confused about effects of interest rate changes on exchange rates. As per the Interest Rate Parity theory, if interest rates of country A increase, with respect to its counterpart country B, the currency of A should devalue to remove arbitrage opportunities. However, I regularly read in the media, that a certain country’s currency devalued as a result of its decision to cut down its interest rates.
For example the following excerpt talks about how the Canadian dollar appreciated as result of the US cutting its interest rate. Could you please help me understand this?.
‘When Canadian interest rates are markedly higher than those in the US, Canada becomes a more attractive destination for interest sensitive capital flows. This situation results in higher demand for short-term assets in Canadian dollar and thus places upward pressure on the dollar itself. When Canadian interest rates are lower than, or comparable to those in the US, the opposite holds true and the Canadian dollar typically weakens.’ (source:http://dsp-psd.pwgsc.gc.ca/Collection-R/LoPBdP/EB-e/prb0322-e.pdf
It plays a part but it is just a small force on exchange rates compared to inflation. If we had a fixed money supply and interest rates went up and down in a country based on real capital savings and demand, then, yes, the actual exchange rates would approach the interest rate parity theory. However, when the fed lowers the interest rate it creats a lot of money to do so and any revaluation the currency should have due to the interest rate parity theory is well exceded due to the debasement of the currency which causes inflation that makes everything more expensive - cereal, oil, gold, and other currencies. so when the fed cuts rates, basically the currency falls due to inflation concerns.
Thanks. So, inflation worries offset the appreciation due to the IPP relation.
However, I am confused because of a news I read recently. I read in the media that the Eurozone inflation has reached at 3.6%, which makes the chances of ECB cutting interest rate remote, and that has propelled the Euro at record levels agains the US dollar. For your reference, please see this link . http://www.reportonbusiness.com/servlet/story/RTGAM.20080416.weuroecon0416/BNStory/robNews/JAN+STRUPCZEWSKI
My question is How the Euro is still appreciating against the US besides the record inflation in the Eurozone?
