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Real exchange rates and real interest differentials: Have we missed - people bu

Real exchange rates and real interest differentials: Have we missed - people bu 2025

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The paper investigates the relationship between real exchange rates and real interest differentials during the floating-rate period, finding a significant link primarily at trend and business-cycle frequencies. Unlike previous studies that focused on high-frequency data and found no correlation, this research employs band-spectral methods to reveal that the strongest correlations occur at lower frequencies. The author critiques existing theories of exchange rate determination, suggesting they inadequately explain the observed data. A new statistical model is proposed, indicating that while there is some correlation between real interest differentials and temporary components of real exchange rates, the overall relationship remains weak.

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How do interest rate differentials affect forex trading?

Traders in the forex market use interest rate differentials when pricing forward exchange rates. Based on the interest rate parity, a trader can create an expectation of the future exchange rate between two currencies and set the premium, or discount, on the current market exchange rate futures contracts.

What are the effects of interest rate differentials?

As mentioned, currencies with higher interest rates tend to attract more investment. This influx of capital can lead to an appreciation of the currencys value in foreign exchange markets. Consequently, a consistent IRD could cause long-term currency movements, affecting global trade and finance.

How do interest differentials cause exchange rates to change?

As a result, monetary policy that impacts national interest rates changes the value of that countrys currency. A residual impact of raising or decreasing interest rates is that the currency value will become stronger or weaker, and downstream impacts on global exchange rates occur.

What is the relationship between interest rate differential and exchange rate?

For given expectations about the future level of the exchange rate, the longer a given change in the interest rate differential between two countries is expected to last, the larger will be the immediate change in the exchange rate.

What is the relationship between the real interest rate and the real exchange rate?

A higher U.S. real interest rate increases the attrac- tiveness of U.S. assets, leading to an increase in the demand for dollar-denominated assets and an appreciation of the real exchange rate. Then, for given price levels at home and abroad, the nominal exchange rate also tends to rise.

Do true or false interest rate differentials cause exchange rate changes?

Differentials in Interest Rates Higher interest rates offer banks and other lenders a better return relative to other countries. Higher interest rates attract foreign capital and cause the exchange rate to rise.

How do interest rates affect the exchange rate?

When interest rates rise, the currency of that country typically strengthens, leading to a higher exchange rate. This means you may get more foreign currency for the same amount of money when sending it abroad.