Reading 23: Capital Market Expectations－LOS p

Higher interest rates generally attract capital and increase the domestic currency value. At some level though, higher interest rates will result in lower currency values because the high rates may stifle an economy and make it less attractive to invest there.

The savings-investment imbalances approach begins by stating that a savings deficit exists when investment is greater than domestic savings. To compensate for a savings deficit, a countrys currency must increase in value and stay strong to attract and keep foreign capital. At the same time the country will have a current account deficit where exports are less than imports. Although a current account deficit would normally indicate that the currency would weaken, the currency must stay strong to attract foreign capital.

The capital flows approach states that long-term capital flows will flow to where the best opportunities are, thus increasing that countrys currency value.

A savings deficit exists when investment is greater than domestic savings. To compensate for a savings deficit, a countrys currency must increase in value and stay strong to attract and keep foreign capital. This scenario typically occurs during an economic expansion when businesses are optimistic and use their savings to make investments. Eventually though the economy slows, investment slows, and domestic savings increase. It is at this point that the currency will decline in value.