Appreciation of the $A question? (1 Viewer)

[seano77]

Why do higher interest rates encourage capital inflow and hence an appreciation? The only reason I can think of is that investors receive a grater return. But wouldn't the business environment be less favourable to invest in during a time of high interest rates?

 

[xsjado]

The high interest rates encourage foreign savings.
I don't know if high interest rates would make businesses less favourable to invest in.

Because Firms can always borrow from overseas anyway...

 

[cs01001]

Yeah, you are right with the part about investors receiving a greater return.
As higher interest rates make it lucrative to invest in Australia, it will lead foreigners wanting to exhchange MORE of their own currency for $AUD so to invest here. An increase in demand for $AUD (illustrated by the shift from D1D1 to D2D2 will hence lead to the appreciation of $AUD (illustrated by the increase from P1 to P2). Like this:

[Image from Wikipedia]

Not entirely sure about the second part of your question, but I am pretty sure higher interest rates will attract more investors to invest, as I mentioned above. You're probably thinking of inflationary effects which makes the economy less favourable to invest in.

 

[gnrlies]

Yes consider the following example...

For simplicity sake assume the lending and borrowing rates are the same and there is no inherent risk in lending or borrowing.

Interest rates in USA = 4%
Interest rates in Aus = 8%

Would it not make sense for an American to borrow at 4% and invest it in a bank account in Australia earning 8%? Of course it would make sense. So when our rates are higher we attract a capital inflow. Because only australian dollars are accepted in Australian banks there is an increase in demand for AUD.

If this were allowed to happen idefinately it would be a never ending money making scheme. As we know there is no such thing. There is a term in economics known as arbitrage whereby you make profit for doing nothing more than selling something for a higher price than you purchased it for. In this case an arbitrage profit is being made on finance (i.e. you buy at 4% and sell at 8%). Because markets are fairly complete and efficient, people will start to realise that some money can be made.

More and more people will do this until the Australian dollar increases to the point that no arbitrage can be made, i.e. it has appreciated so much that even though you are earning more interest in Australia; you don't get as much in return as when you seek to acquire you funds back you now get less US dollars.

Of course my above explanation is a gross oversimplification but its essentially the raw theory about how it all works.

 

[munchiecrunchie]

Why do higher interest rates encourage capital inflow and hence an appreciation? The only reason I can think of is that investors receive a grater return. But wouldn't the business environment be less favourable to invest in during a time of high interest rates?

Like it has been explained in previous posts, it encourages speculative funds into the country, in order to take advantages of the higher rates of return.

In relation to the 2nd part of the question, higher interest rates do discourage domestic businesses to invest, as the cost of borrowing funds to undertake that is higher. However, higher interest rates (I think, not completely sure on this one) creates greater certainty for overseas investors, as they can see that the govt is acting to control inflationary pressures to create a low inflation environment, which hence increases the confidence of overseas investors.