[nestle_life]

I’m a beginner at economics so I’m trying to get a better grasp at this…these two questions are really confusing and I don’t understand why things can’t be simpler…here they are:

1. If the central bank of a country raises interest rates sharply, the country’s currency will most likely:

Answer: Increase in relative value.

OK, fine, but read question 2.

2. Assuming exchange rates are allowed to fluctuate freely, what will likely cause a nation’s currency to appreciate on the foreign exchange market?

Answer: A slwoer rate of growth in income than in other countries, which causes imports to lag behind exports.

The answer was NOT: A high rate of inflation relative to other countries.

I don’t understand the contrast. In the first question, it says if you increase IR, the currency value also increases. Ok, fine. The second says says, “High rate of inflation, which means higher interest rates, will not increase currency value” and instead some answer about an export is the answer. WHAAAT!!! This makes no sense!

[stoleway]

Do not confuse interest rate with inflation, interest rate is not used to measure inflation.

Consumer price index( changes in prices from time to time ) is the basic tool used to measure inflation.

Back to your question, if interest rates rises relative to that of other countries, the demand for the domestic currency will increase. This increase in demand is as a result of influx of other foreign currencies seeking higher returns in the domestic economy. This increase in demand will also lead to a decrease in supply of the local currency, which will cause the country's currency to increase in value relative to other currencies.

Finally, assuming it was the dollar that has increased in relative value, other countries will find American export as very expensive, so export decreases. On the other hand, the $ has more power and will able to purchase more good from other countries, so import increases. Hope this helps

REG -63│ 84!!
BEC- 59│70│ 71 │78!
AUD- 75!
FAR- 87!

Mass-CPA

[spinfuzer]

Inflation depreciates the value of currency. The more currency there is, the less each unit of currency is worth.

Deflation appreciates the value of currency.. The less currency there is, the more each unit of currency is worth.

If you increase the interest rate and make it more expensive to borrow money, does this increase or decrease the amount of money that is out there?

FAR - 08/08/14 - 93
BEC - 08/28/14 - 95
REG - 10/11/14 - 96
AUD - 11/30/14 - 99

[h0wdyus]

Increase in interest rate affects the demand mainly and supply to some extent. If rate is high the demand for money goes down. Think of mortgages.

The supply will increase for money if interest rate is high, but there may not be many takers.

So interest rate manipulation as a Monetary Policy tool used by Central bank is to reduce or increase DEMAND for money.

As a side note, when interest rate is high, the value of the currency increases because other country investors buy the currency to invest in the country which is paying higher interest rate. Think about it, would you like to invest in a country paying 10% interest rate or in a country paying 2 %rate, keeping the currency fluctuation risk constant. You will have to buy the currency of the country paying 10% interest rate so that you can invest in Time deposits over there at 10%. The key is you will need to buy which will raise the price of the currency which is paying higher interest rate.

Further once interest rate is raised in a country inflation reduces because spending decreases , due to higher cost of money. Once spending decrease inflation also comes down. That is the demand pull inflation comes down.

FAR - 81 29th Aug 2013
AUD - 84
REG - 82
BEC - 89 29th Aug 2014
Using Yager

FROM NJ

[stoleway]

@spinfuzer…

Just adding to what howdyus said, increasing interest rate is one of the measures used to curb inflation.

Interest rate increment is used by the feds to reduce money supply, people start saving chunk of their money when interest rate is high.

In summary, the feds are basically trying to reduce money supply and curb inflation when they increase interest rate.

REG -63│ 84!!
BEC- 59│70│ 71 │78!
AUD- 75!
FAR- 87!

Mass-CPA

[nestle_life]

So what I'm getting from this is….just because inflation is happening doesn't mean interest rates are going to increase. Is that correct? But I thought it was sort of an automatic response by the government…to reduce spending by consumers.

So interest rates and inflation are sort of independent of each other?

[h0wdyus]

@nest

usually Central Banks ( FED) will raise interest to curb inflation. Sometimes inflation is a good thing, since it reflects growth in the economy too. Some inflation is good. So it is NOT necessary and NOT automatic that fed will increase interest rate when inflation is high.

As in the case of US economy the FED actually pumped money into to the market by reducing interest rate, to create inflation, to make inflation.

The manipulation of interest rate depends on future outlook of the economy and other political concerns. Rising inflation does not mean the Fed will raise interest rate every time.

Interest rate is just ONE of the tools to curb inflation, one of the most effective tools that FED's use is the monetary policy of “open Market Operations” in that the feds will sell US treasury so they can remove money sloshing around in the market. Since when they sell they get money out peoples hands and that also curbs inflation.

Fiscal policy that is the policy that the govt uses.. monetary policy is used by FED's . Fiscal policy of increasing taxes also reduced the buying power of people and reduces inflation. So as you see interest is JUST one of the ways of controlling inflation.

FAR - 81 29th Aug 2013
AUD - 84
REG - 82
BEC - 89 29th Aug 2014
Using Yager

FROM NJ

[Author]

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