Relationship among Inflation, Interest Rate and Foreign Exchange Rate

Inflation is the price high of essential commodities over a time period of one year. It is the spirit
of devaluation of money. Devaluation of money refers to the reduction in the purchasing power,
money loses its purchasing power over the time which is known as inflation. Inflation can be
viewed as either of two ways1. Additional amount of money the consumer requires to get same amount of commodity or
2. Reduction in the quantity of commodity at the same price.
Inflation is the reason for many causes like supply of money, demand for the product, growth of
the economy, demand for foreign product etc. Supply of money refers to the velocity of money.
Money supply is provided by Central Bank.
If supply of money increases the demand for the product will increase, the additional demand
will increase the price of commodity. Both demand and supply of commodity have the impact on
the inflation. The higher the supply of money the greater the inflation, the higher the demand, the
higher the price of product, therefore greater the inflation.
The national growth rate also affect the inflation. The growth rate indicates that the level of
income of the people will increase, therefore their demand for the product also increase and that
will cause also the inflation. The level of the income affects the demand for the product. The
higher the level of the income of the people the higher the demand of the product which also
causes inflation.
If the per capital income is higher, then the standard of living of people will increase. Then
saving and investment affect the inflation. Saving can be defined as postponed consumption,
reduction of consumption or curtail of consumption. Nobody cant save money without reducing
consumptions. At a given level of income, reduction in expenditure will increase the saving or at
a given level of expenditure increase in income will generate saving. Saving is the excess amount
of income over expenditure. If people save more the money, the money circulation will be
reduced and velocity of money will also be lower, as a result inflation will decline.
According to J. M. Keynes, savings of the society, people, and government must be converted
into investment. So if the rate of savings increases investment will increase and people will
reduce the consumption that will reduce inflation. Therefore investment and savings directly
influence inflation.

Still investment has a positive impact on inflation. The side effect of inflation is that if
investment increases the output and income of the people also increases that may turn to positive
impact on inflation, because investment increase productivity of an economy, so these are the
reasons of inflation. Inflation is macroeconomic variable that affect the economic growth. So
inflation is not a curse, it helps the economy.
Effect of Inflation on Interest

The components of interest are the inflation and risk free real rate of return (RFRR). RFRR is the
excess amount of nominal rate of return or stated market rate over the inflation. Since inflation is
policy variable and government can control it. Market interest rate is determined by the central
bank through monetary policy. The expression isRFRR + Inflation = Nominal rate of interest
Nominal interest rate should be higher than inflation. Difference between nominal rate and
inflation is the risk free rate of return. Individual must desire a rate of return that can offset
inflation. Real rate increase the value of asset over time. It increase the quantity of money for
assets. Around the world this real rate is assumed to be same. If it is same or given all over the
world, inflation is the indicator that determines the interest rate. So higher the inflation the larger
interest rate because at a given level of interest inflation depends on interest rate and lower the
interest rate and lower the inflation rate.

Impact of Interest Rate on Foreign Exchange Rate

If interest rate varies at different countries the differential interest rate prevails at different market
which is the interest rate discrimination. Interest rate discrimination is the cause of the change in
exchange rate. The effect of interest rate on the exchange rate can be determine by forward
margin. Which is-

P= ((1+ih)/(1+if))-1
So the difference between ratio and 1 is the premium.

Suppose in Bangladesh interest rate is 10% and England it is 8% and spot rate of Pound is
TK.125, now what would be the forward rate? What would be the impact of interest rate on
foreign exchange rate for Bangladeshi people and the British people?

Impact for Bangladeshi people:

For Bangladeshi people home currency is taka. Therefore
P= ((1+.1)/(1+.08))-1
= 0.0185

It is forward premium which is positive. Therefore the forward rate after one year will beF1=So(1+p)

= TK.125 (1+0.0185)
= TK.127.3125
What would be the exchange rate for British people?
Suppose British people invest in Bangladesh.
P= ((1+.08)/(1+.1))-1
= - 0.01818
-0.01818 is the forward discount that is forward rate would be lower than spot rate, and therefore
forward rate would be-

TK. 125(1- 0.01818)

=TK. 122.75
So forward rate TK. 125.75 would be the after one year and TK. 125.75 which is the different
from spot rate. Now question is that who will exercise which rate to equate the interest rate
discrimination, which described by interest rate parity theory.

Interest Rate Parity (IRP) Theory

IRP theory asserts that foreign exchange rate will be barried difference to offset the interest rate
discrimination.
British people use 8%, alternatively will use spot rate of TK. 122.75 and Bangladeshi people will
use TK. 127.3125 to covert foreign currency into their own currency to offset the interest rate
discrimination between countries.
Forward Return/ Forward transaction
Forward return is the contract between parties to exchange certain amount of currency at a
certain future price at a future date. As per forward contract if the price is predetermined the
forward contract is known as forward option.
An option is the right but not obligation given to its holder to purchase or sell a certain amount of
currency at a certain price at or within certain future date, here the price is known as strike price.
The maturity date is known as termination. If the market price higher than the strike price, price
is known as in the money. If market price is lower than the strike price the contract is out of the
money, but if market price and strike price are same the contact is on the money.

Option are two types1. Call Option

2. Put Option
Call option is to purchase currency at future date. Put option is the right to sell the currency at a
fixed price in the future. Then currency futures or future contract refers to the contract to trade
certain quantity of currency at a certain price at a certain future date.

Difference between Forward and Future Contract

Future contract can be transected in the exchanges it is the standardized amount of

currency, but forward contract cannot be transected in exchanges rather it is transected
over the counter.
Future contract take place between the brokerage. On the other hand forward contract
take place between banks and corporate clients