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Relation b/w Inflation, Interest Rates and Exchange rate. (Doubt)?

Qs.
What happens when the inflation is decreasing, to the exchange rate?


1st Explanation:
As inflation is decreasing, the cost of producing the goods will decrease and this in turn will make our exports cheaper as compared to other countries producing similar goods.
Increased exports will induce more interests into Indian Currency and thus it will Appreciate.

But if I think on other lines,
As Inflation decreases, RBI will further reduce it's Interest Rates, ie Repo to spur growth.
Once our Interest Rates decrease, Global investor will not want to invest here and take their money away.
This, on the Contrary will Depreciate our currency.

These 2 lines of thought are a bit confusing.

Can someone will clear understanding the relation between:
Inflation,
Interest Rates
and Exchange Rates
explain how to think?







Comments

  • Both line of thoughts are correct, they work concurrently or at times one takes over other

    Eg. cheaper domestic prices push export and discourage imports = trade balance positive = chance of currency appreciation

    To neutralise this rbi would infuse liquidity ( lower rates to increase money supply in economy ) this would reduce rate of interest = May lead to capital outflow thereby limiting currency appreciation due to point 1.

    Here both instruments need to be used cautiously in balanced way otherwise chance of point 2 overstretching it’s mandate that is not just limit appreciation but might lead to depreciation as well .
  • carrie said:

    Both line of thoughts are correct, they work concurrently or at times one takes over other

    Eg. cheaper domestic prices push export and discourage imports = trade balance positive = chance of currency appreciation

    To neutralise this rbi would infuse liquidity ( lower rates to increase money supply in economy ) this would reduce rate of interest = May lead to capital outflow thereby limiting currency appreciation due to point 1.

    Here both instruments need to be used cautiously in balanced way otherwise chance of point 2 overstretching it’s mandate that is not just limit appreciation but might lead to depreciation as well .

    +1explained very well.
  • edited March 17
    It's all about to promote growth and development in a sustained and balanced way.
    And for this ultimate goal different policies and tools are used by the STATE.
    Which may affect--
    1.Demand and supply
    2.Production and consumption.
  • when prices fall, the real interest income rises - that this, the net return on investments in bonds, deposits etc. This attracts more foreign investment because actual rate of return is higher.

    For instance, in a country if nominal interest rate is 8% and inflation is 7% real interest rate is 1% (8-7) But if inflation falls to 5% , it increases to 3% (8-5).

    This inflow leads to currency appreciation.

    Along with this, exports become cheaper over time as cost of production falls. However, there is a time lag here and export revenue doesn't rise immediately. Domestic prices also fall compared to imports.

    The rule is that money market changes are faster than the changes in goods market which are tied up in production lines.

    Nonetheless, the exchange rate appreciates inevitably as the value of our currency is more now.

    A side note,
    Now RBI may choose to cut repo to spur lending further. However, this is contingent on the medium term inflation outlook. So you can't really say it will definitely do this. Unless explicitly mentioned in the question, we assume this is unchanged.

    Central banks usually cut interest rates to spur growth in a slump or promote investment. The finance ministry usually wants them to cut rates to promote growth with higher inflation. There is a clear cut tussle.

  • Thanks for the explanation. @all.
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