real interest rate vs inflation effect - just don't get it currency, interest, understand

Kapie

I am thoroughly confused with the effect of real interest rate increase and inflation. I understand the increase in real interest rate increases capital inflows and hence causes appreciation of domestic currency.

But inflation seems to have a negative effect- is it because the exchange rate falls as a result of increased inflation?


I am so confused with this whole topic - am not even sure my question makes sense.

Ok my question is why isnt the increase in real interest rate have the same impact on the nominal interest rate(which is what i assume all the equations are based on). I.e increase in real interest rate causes a fall in exchange rate as well.

madaochenggong

The real interest rate does not adjust itself to inflation -- its is the nominal interest rate that changes upon inflation. The real interest rate is based purely on demand supply factors

skwak88 Wrote:
-------------------------------------------------------
> why does it not make sense?
>
> suppose Ghana's nominal int rate is 9.0% and the
> expected inflation rate is 3.5%.
> Real interest rate then is, (1.09) = (1+real int
> r)(1.035). Solve for real int r and get 5.3%. In
> other words, nominal interest rate should in
> theory be explained by inflation and real interest
> rate.

tobeornottobe

skwak88 Wrote:
-------------------------------------------------------
> wbrocks, nominal = real + inf is the same thing as
> (1+nom) = (1+real)(1+inflation). The latter is
> actually the more precise measure, whereas the
> prior is an approximation.

Sorry, you're right. I just remembered the Level 1 curriculum stating that the nominal rate could be calculated both ways, with just a slight difference. I edited the post as soon as I realized it. Wow, you guys were fast to jump on that.



Edited 3 time(s). Last edit at Tuesday, May 24, 2011 at 04:08PM by wbrocks.

needhelp1700

wbrocks -- thats a simplification of the actual formula

YAhmed

why does it not make sense?

suppose Ghana's nominal int rate is 9.0% and the expected inflation rate is 3.5%.
Real interest rate then is, (1.09) = (1+real int r)(1.035). Solve for real int r and get 5.3%. In other words, nominal interest rate should in theory be explained by inflation and real interest rate.

scarecrow

wbrocks, nominal = real + inf is the same thing as (1+nom) = (1+real)(1+inflation). The latter is actually the more precise measure, whereas the prior is an approximation.

liquidity

the r in interest rate parity is nominal return.

$/L *(1+Nominal return $)/(1+Nominal Return) = Forward $/L


i think this idea also is that real rates accross borders are all equal (if they werent, then investors would flood the country with higher rates, setting them to equilibrium). So real rates are assumed to be equal accross countries, then differences in nominal yields are due to inflation. I think that makes sense.

SFoyil

Think of it in real terms. If inflations rises, real rates turn lower. Real interest rates falling causes domestic currencies to depreciate.