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I understand that if interest rates of a country A is higher than that of B, then that draws foreign investment from B to A thus strengthening the currency of A. In other words, a high interest rate usually means a strong currency.

Is this correct? IF so, then why is the currency of India so weak as opposed to the USD even though interest rates in India are much higher. Is inflation somehow the cause for this?

edit: I ask this because I wish to know when I should invest in USD over INR if I were 'fairly' certain about future interest rates.

  • Interest rates are from a central bank which may belong to one or more countries. The Euro for example has interest rates that apply to multiple countries so be careful of your wording here. – JB King Jan 19 '14 at 18:21
  • I can see a correlation between currency and personal finance, but would you please edit the connection into your question? We don't handle economics; if you can connect this to you wanting to understand the risks of an investment strategy or opportunity it would be better. – MrChrister Jan 19 '14 at 19:08
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What you are asking about is called Interest Rate Parity. Or for a longer explanation the article Interest Rate Parity at Wikipedia.

If the US has a rate of say zero, and the rate in Elbonia is 10%, one believes that in a year the exchange rate will be shifted by 10%, i.e. it will take 1.1 unit of their currency to get the dollars one unit did prior.

Else, you'd always profit from such FOREX trades.

(Disclaimer - I am not claiming this to be true or false, just offering one theory that explains the rate difference effect on future exchange rates.

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From Indian context, there are a number of factors that are influencing the economic condition and the exchange rate, interest rate etc. are reflection of the situation. I shall try and answer the question through the above Indian example. India is running a budget deficit of 4 odd % for last 6-7 years, which means that gov.in is spending more than their revenue collection, this money is not in the system, so the govt. has to print the money, either the direct 4% or the interest it has to pay on the money it borrows to cover the 4% (don't confuse this with US printing post 2008). After printing, the supply of INR is more compared to USD in the market (INR is current A/C convertible), value of INR w.r.t. USD falls (in simplistic terms). There is another impact of this printing, it increases the money supply in domestic market leading to inflation and overall price rise. To contain this price rise, Reserve Bank of India (RBI) increases the interest rates and increases Compulsory Reserve Ratio (CRR), thus trying to pull/lock-up money, so that overall money supply decreases, but there is a limit to which RBI can do this as overall growth rate keeps falling as money is more expensive to borrow to invest.

The above (in simplistic term) how this is working. However, there are many factors in economy and the above should be treated as it is intended to, a simplistic view only.

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