I've seen both arguments. From my understanding an increase in the rate of inflation should decrease the value of the currency since it's by definition a depreciation in its purchasing power. But I've heard people argue that an increase in inflation actually increases the value of a currency since that country's Central Bank is expected to hike its rates which makes that country's financial assets more attractive and thus increases that country's currency value through an increase in the demand for that currency.

Which of these two views make more sense theoretically and which is more supported empirically?

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    $\begingroup$ Currency markets are a financial market. If any variant of the “efficient market hypothesis” holds, it is very difficult to beat the market. If there were a solid statistical relationship between inflation - which also can effectively be traded in the inflation swap market - and currencies, it would probably imply an opportunity to make money “relatively easily.” This logic would suggest that empirical linkage will be weak. On a longer-term basis, you could look up “purchasing power parity.” $\endgroup$ – Brian Romanchuk May 13 at 17:06

I've seen both arguments. [...]

You are comparing two arguments that are not incompatible. The first one scenarizes a situation within which the CB does nothing, while the second argument implies a CB that counteracts. Note that when the CB hikes its rates, it also has some forex-unrelated domestic consequences going in the same direction.

Which of these two views make more sense theoretically [...] ?

As explained, both. It is all about politics actually. There is no deterministic math here. Put differently, human is an unpredictable variable in the model.

Which [...] is more supported empirically ?

Once again, both. Notorious investments such as Soros's against the British pound in 1992 perfectly illustrates the second argument. But if Britain hadn't done anything to keep the pound's value high (in relation to the German mark), it would have decreased because of inflation.

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  • $\begingroup$ What about the argument, for the second case, that a rate hike by the CB is actually inflationary and not deflationary as is usually thought of since the government is a net payer of interest and thus a rate hike increases private income. I've mainly seen this argument from Post-Keynsians and MMT'ers. $\endgroup$ – Metrician May 14 at 15:44
  • $\begingroup$ @Metrician Since your additional question is independent of the current post, consider asking another question. I am sure that you understand that comments are not adapted for Q&As. Any question regarding my above answer ? $\endgroup$ – keepAlive May 14 at 21:28
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    $\begingroup$ I thought it related to it since if they're correct that would mean that a rate hike should further depreciate the currency's value eitherway in those two cases. Other than that everything else is clear thanks. $\endgroup$ – Metrician May 14 at 23:22

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