Interest Rates & foreign Exchange & inflation

Tim Robbins

Hi,
The rate of change of interest rates influence the rate of change of foreign exchange influecnes the rate of change of inflation.
Can anyone explain the exact nature of this relationship?
Rgds

Économiste Monétaire

The rate of inflation and the real interest rate are interlinked by the Fisher effect. The real interest rate is got by taking the nominal interest rate and minus the inflation rate. Thus if there is a higher inflation rate then there needs to be a higher nominal interest rate to give a positive real interest rate.

If the domestic inflation rate is high then that will increase the demand for imports due to the increased price of domestic goods. The imports must be paid for with foreign currency and thus raising the demand for foreign currency will effect one currency's exchange rate against the importing nation. So increased domestic inflation will weaken one currencies rate against another.

International Fisher effect: foreign currencies with relatively high interest rates will depreciate because the high nominal interest rates reflect expected inflation

The higher the domestic (Irish) interest rate the more incentive there is for foreign investors to place their money in Irish banks (as euro), thus affecting the exchange rate by increasing the demand for Euros against the dollar.

Thats pretty basic and its off the top of my head.

portomar

i believe fractional reserve banking also has a big effect on inflation, as much of the money supply is created by leveraged borrowing.starting to unravel now. as an aside has any government ever tried to put a dampner on inflation by increasing the money it requires banks to keep on deposit?

Économiste Monétaire

China increases the reserve requirement to fight inflation (http://news.bbc.co.uk/1/hi/business/7089307.stm), they did it nine times in 2006. This side of the world tends to use OMOs because of the difficulties that result to banks.

ShaneMR

Is there any indicators that have high correlations with the USD/EUR exchange rate?

I know that interest rate differentials and other currency pairs do. But can anyone think of any others?

Regards,

Shane

portomar

UCD_Econ wrote: »

China increases the reserve requirement to fight inflation (http://news.bbc.co.uk/1/hi/business/7089307.stm), they did it nine times in 2006. This side of the world tends to use OMOs because of the difficulties that result to banks.

any idea where i could find irish/EU/eurozone figures on reserve requirenments??

Économiste Monétaire

http://www.ecb.int/mopo/implement/mr/html/calc.en.html

portomar

UCD_Econ wrote: »

http://www.ecb.int/mopo/implement/mr/html/calc.en.html

cheers!

Économiste Monétaire

portomar wrote: »

cheers!

You're welcome.