Central banks typically respond to weakening currency values by using a combination of higher domestic interest rates and foreign exchange market intervention. Higher real interest rates tend to lead to an appreciation of the currency. This is because high-interest rates mean saving in that country gives a better return. Therefore investors often move funds to countries with higher interest rates.

Let us first examine interest rates before taking a critical look at both arguments. In this article we will explore about interest rate hikes and the causes of inflation and currency depreciation.

What are Interest Rates & Interest Rate Hikes?

Interest rates are the cost of borrowing money. These rates are constantly changing, and differ based on the lender, as well as your creditworthiness. Interest rates not only keep the economy functioning, but they also keep people borrowing, spending, and lending. Interest rate cuts & Hikes not only affect country’ economy it also affect personal finance.

Have you ever wondered what an interest rate hike or cut means for your personal finances? When the Federal Reserve changes rates, it can influence how much interest you pay on things like loans and credit cards, as well as the amount you could earn on savings accounts. Rising interest rates increase the cost of credit cards, loans, and mortgages. They also improve the interest you can earn on savings accounts and certificates of deposit. Interest rates stopped rising in 2019. As of September 2020, the Fed doesn’t plan on increasing them again until at least 2023. At the Federal Open Market Committee (FOMC) meeting in November, the Fed confirmed that it would maintain its target for the fed funds rate at a range of 0% to 0.25%. The Fed doesn’t plan on raising the fed funds rate until at least 2023, or until the economy improves. Historically, the benchmark rate has had a sweet spot of 2% to 5%. The highest it’s ever been was 20% in 1980 and 1981.

Rising Interest Rates

So the exchange rate response to an interest rate change is an important transmission channel for monetary policy, in addition to the fact that the exchange rate is probably the most important price in any economy, since it affects all other prices.  Raising interest rates reduces growth in aggregate demand in the economy, which leads to lower inflation. This assumption rests on demand-pull effects, which also suggest that raising interest rates reduces consumer spending and investment because the cost of borrowing increases and saving becomes a more attractive option. The increase in saving reduces the supply of money in circulation, curbs inflation, and increases the value of the currency. Appreciation of the currency hurts the export sector and eases potential wage pressures since labor demand declines as a result of reduced competitiveness for local tradable goods and services.

Inflation

Inflation can broadly be described as a rise in prices of products in an economy. Thus, the so-called “purchasing power” of a currency is affected. This simply means that when prices rise, it takes more and more money to buy the same amount of goods as it had taken before. High inflation leads to shortages in goods, as was seen in the late 1970’s and early 1980’s. The opposite of inflation is deflation, a sustained decrease in the general price level of goods and services. The common measure of inflation is the inflation rate, the annualized percentage change in a general price index, usually the consumer price index, over time.

What Causes Inflation?

It is generally an increase in the money supply of a country that outpaces economic growth or the increase in the price of goods of a country. The money supply increases when the Treasury prints more money or issues an excessive amount of debt that is purchased with their base currency. Prices of goods go up at a rate that does not keep up with consumer demand

Inflation is generally a bad thing for an economy, as it discourages investment, especially in fixed income instruments (bonds and currencies). It hurts consumers, who see their paychecks become worthless, and their costs increase. During inflationary periods, investors do not want to buy debt instruments issued by a country, because they are denominated in the currency that is being devalued due to the inflation. Some economists view some inflation necessary to help an economy overcome a recession or a large debt burden. This is generally referred to as “inflating your way out of debt.” This has long-term negative consequences on a country as it causes currency depreciation.

Currency Depreciation

Currency depreciation is a fall in the value of a currency in a floating exchange rate system. Currency depreciation can occur due to factors such as economic fundamentals, interest rate differentials, political instability, or risk aversion among investors. Essentially, a currency depreciates because of a loss of investor confidence. Extreme losses of confidence can have a severe effect on a currency and by extension, economic health.

What Causes Currency Depreciation

Countries with weak economic fundamentals, such as chronic current account deficits and high rates of inflation, generally have depreciating currencies. Currency depreciation, if orderly and gradual, improves a nation’s export competitiveness and may improve its trade deficit over time. But abrupt and sizable currency depreciation may scare foreign investors who fear the currency may fall further, leading them to pull portfolio investments out of the country. These actions will put further downward pressure on the currency.

Easy monetary policy and high inflation are two of the leading causes of currency depreciation. When interest rates are low, hundreds of billions of dollars chase the highest yield. Expected interest rate differentials can trigger a bout of currency depreciation. Central banks will increase interest rates to combat inflation as too much inflation can threaten a nation’s economic stability and cause currency depreciation. Additionally, inflation can lead to higher input costs for exports, which then makes a nation’s exports less competitive in the global markets. This will widen the trade deficit and cause the currency to depreciate.

Difference between Inflation and Currency Depreciation

Your confusion might be mitigated if you thing about Inflation and Currency Depreciation. That is, the more immediate effect of inflation is that exports fall, demand for currency falls, and so the value of currency falls. This causes imports to fall, domestic spending to increase, and foreign demand for domestic goods to increase. That is, exports rise. This increase in exports causes an increase in demand for the home currency and this puts upward pressure on the currency. The short-term effect of inflation is that we have currency depreciation. The long-term effect is less clear cut, since the depreciation should trigger an increase in foreign demand which should counteract the initial effect of inflation.

1. We need to be clear about what is a cause and what is an effect. Increased prices in goods in a country –> the country’s exports will be less competitive –> so demand for the exports fall –> demand for the country’s currency falls –> and this leads to depreciation of currency

In the first statement, prices rose. Why? An increase in the domestic money supply, presumably? If so, then essentially we have changed numeraire. What used to be a dollar’s worth of goods now costs $1.10, both domestically and abroad. If the numeraire did not change abroad and nothing changed about the economy, then a unit of the foreign currency now buys the same amount of goods but more dollars.

2. That’s depreciation of the currency. Depreciation is the effect, not a cause. 5with a depreciated currency -> imports will be more expensive BUT the country’s exports will be cheaper and more competitive –> then won’t demand for currency rise instead?

In the second statement, there has been depreciation. Why? Because of an increase in the money supply as mentioned above? If so, then demand for currency will only rise in as much as an importer of the same amount of goods will need more dollars, but this numerical increase in demand doesn’t translate to making the dollar worth more abroad. The depreciation is the equilibrium result of the change in the money supply. Again, depreciation is the effect.

For depreciation to be a cause, rather than an effect, you would need to provide an economic change that directly affected depreciation. Depending on what changed economically, there could be lots of possible outcomes.

Conclusion

Economists generally believe that very high rates of inflation and hyperinflation are harmful, and are caused by an excessive growth of the money supply. Inflation affects economies in various positive and negative ways. The negative effects of inflation include an increase in the opportunity cost of holding money, uncertainty over future inflation which may discourage investment and savings, and if inflation were rapid enough, shortages of goods as consumers begin hoarding out of concern that prices will increase in the future. Positive effects include reducing unemployment due to nominal wage rigidity, allowing the central bank more leeway in carrying out monetary policy, encouraging loans and investment instead of money hoarding, and avoiding the inefficiencies associated with deflation.

A general rule of thumb is that a central bank will increase interest rates to tame inflation and decrease interest rates as inflationary pressures become less evident. A low borrowing rate encourages consumers to borrow more money, thus pumping more cash into the money supply. When interest rates are raised, the intention is to choke off this excess supply of cash. Today, most economists favor a low and steady rate of inflation. Low (as opposed to zero or negative) inflation reduces the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduces the risk that a liquidity trap prevents monetary policy from stabilizing the economy. The task of keeping the rate of inflation low and stable is usually given to monetary authorities.