Question

Economic logic may tell us that a country with a higher interest rate, thus a higher rate of return, should be able to attract foreign capital and that a country with a lower interest rate, thus a lower rate of return, should experience an outflow of capital. If a country is experiencing a large net capital inflow its currency is likely to appreciate, while a country experiencing a large net capital outflow would likely see its currency depreciate (assuming a floating exchange rate). However, according to interest rate parity conditions a country with a higher interest rate would see its currency depreciate, while the currency of the lower interest rate country would appreciate. What is the main reason the outcome under interest rate parity conditions?

Question 2 options:

Higher interest rates are a deterrent for investors while lower interest rates are favorable

Investors do not seek higher return

The relative interest rate level is not a factor for investment decisions

The assumption that countries have an identical real interest rate

Answer 1

The interest rate parity conditions are very similar to the law of one price. In a global economy, which is highly competitive and with no barriers to mobility of capital, only one real interest rate will prevail in the world.

Thus, though there may be differentials in the inflation levels and thus nominal interest rates, and accordingly nominal exchange rates will fluctuate, the world real interest rate will remain only one.

Thus, a country with higher interest rate sees its currency depreciate, because of the assumption that countries have an identical real interest rate. After hedging, any difference in interest rates is nullified, due to the changes in exchange rates.