– Inflation (or more precisely differential inflation) influences exchange and interest rate markets.
– The key to remember is that inflation in a given currency affects the future purchasing power of that currency.
– An important determinant of the forward exchange rate between any two currencies is the expectation of differential inflation rates in the two currencies.
– In purely domestic financial markets when money is lent the return one expects to receive is usually stated in nominal terms, or the actual figure you expect to receive.
– What is not guaranteed is what the money will buy. If inflation is expected to exist during the loan period, the real (stated in terms of purchasing power) return is expected to be less than the nominal return. Calculated by;
Nominal interest rate = real interest rate + effect of inflation
(1+ nominal rate)n = (1+ real rate)n x (1+ inflation rate)n
where n is the number of periods in question
– Since money can be kept in any currency it is reasonable to expect that purchasing power parity across time as well as across currencies will be maintained by the foreign exchange market.
– It is not surprising then that the ratio of the forward exchange rate to the spot exchange rate mirrors the ratio of expected inflation rates in the two currencies.
– Interest rate differentials are caused by inflation differentials, which are the root cause of the observed discount or premium on forward exchange.
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