how do interest rates and inflation interact with each other in an open economy? What does a change in either mean for the other?
In: Economics
high interest rates attract foreign investors to invest in the country and get a higher return than they would at home. if the country’s currency is floated i.e. subject to market forces then one way central banks can influence the value of the currency is via the interest rate. raising the interest rate will strengthen the currency while reducing it will weaken the currency.
the difference in the domestic inflation rate and the inflation rate in reserve currency countries will also have to be taken into account by the central bank when setting interest rates. if the interest rates don’t compensate foreign investors over and above the inflation rate they will not invest and the currency will weaken.
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