How changes in relative real interest rates affect exchange rates

Changes in relative real interest rates can have a significant impact on exchange rates. Real interest rates are interest rates that have been adjusted for inflation. When real interest rates in a country rise relative to other countries, the value of that country's currency tends to appreciate. This is because investors are attracted to higher real interest rates, which means that they are willing to pay more for the currency of that country. The following are some of the mechanisms through which changes in relative real interest rates affect exchange rates:

• Capital flows: Investors are attracted to higher real interest rates, which means that they are willing to buy more of the currency of the country with the higher real interest rates. This increased demand for the currency causes its value to appreciate.
• Interest rate differentials: When real interest rates in a country are higher than in other countries, there is a larger incentive for investors to borrow in countries with lower real interest rates and invest in the country with the higher real interest rates. This process, known as the carry trade, can also lead to an appreciation of the currency of the country with the higher real interest rates.
• Inflation expectations: If investors expect inflation to be higher in a country than in other countries, they will demand a higher real interest rate in that country. This increased demand for real interest rates can also lead to an appreciation of the currency of that country.

It is important to note that the relationship between real interest rates and exchange rates is not perfectly straightforward. There are a number of other factors that can also affect exchange rates, such as economic growth, trade flows, and political stability. However, real interest rates are one of the most important factors that investors consider when making investment decisions. Therefore, changes in relative real interest rates can have a significant impact on exchange rates. Here are some examples of how changes in relative real interest rates have affected exchange rates in the past:

• In the early 1980s, the US Federal Reserve raised interest rates in an effort to combat inflation. This led to an appreciation of the US dollar relative to other currencies.
• In the late 1990s, the Japanese economy was struggling and Japanese interest rates were very low. This led to a depreciation of the Japanese yen relative to other currencies.
• In the early 2000s, the US economy was strong and US interest rates were rising. This led to an appreciation of the US dollar relative to other currencies.
• In the late 2000s, the US economy experienced a recession and US interest rates were cut close to zero. This led to a depreciation of the US dollar relative to other currencies.

In recent years, the US Federal Reserve has been raising interest rates in an effort to combat inflation. This has led to an appreciation of the US dollar relative to other currencies. However, it is important to note that other factors, such as the ongoing war in Ukraine and the strength of the global economy, are also affecting exchange rates. It is also important to note that the impact of changes in relative real interest rates on exchange rates can vary depending on the country. For example, the impact of changes in relative real interest rates on exchange rates is likely to be greater in smaller, more open economies than in larger, more closed economies. Overall, changes in relative real interest rates can have a significant impact on exchange rates. This is because investors are attracted to higher real interest rates, which means that they are willing to pay more for the currency of the country with the higher real interest rates. However, it is important to note that the relationship between real interest rates and exchange rates is not perfectly straightforward. There are a number of other factors that can also affect exchange rates, such as economic growth, trade flows, and political stability.  

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