Dollars and Jens
Saturday, July 09, 2005
interest rates
It is well-known in my line of work that forward exchange rates, going out in time, change at a rate equal to the difference between the interest rates in the two currencies — if I lend out $100 for a year, borrow the equivalent amount of pounds, and sell forward the dollars in exchange for pounds at the end of the year, the net result had better be pretty close to a wash, or arbitrageurs would make it become one.

When asking what causes exchange rates, the most straightforward answer is that a certain amount of money ought to buy the same amount of stuff in each country — "Purchasing Power Parity". Anyone who's traveled knows this isn't exactly true, and in some cases, not even approximately — developed countries have much higher prices than undeveloped countries, debtor nations and manufacturing nations tend to have higher prices than others, etc. — but it's generally approximately true that the "real exchange rate" — the ratio of price levels in one country to those in another — holds pretty much constant between developed countries, and tends toward one. This suggests that real interest rates should be the same in all currencies; if I sell a given consumer basket of goods and invest the proceeds, those proceeds should be able to buy the same amount without regard to the currency for which the basket was sold and in which the investment was made.

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