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Suppose a country initiates quantitative easing by printing money and buying government debt. This will put a downward pressure on interest rates. Will this action tend to depreciate the country's currency against USD because money supply has increased decreasing the value of money? Suppose, further, that the final interest rate after quantitative easing is less than the USD interest rate. From interest rate parity, I believe it would follow that the currency would appreciate against the dollar. If yes, there are two opposing influences on the currency. Which one will prevail?

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  • $\begingroup$ For a non-US country, an arbitrary reduction in interest rates will usually immediately weaken its exchange rate against the dollar (not just for money supply reasons). If uncovered interest rate parity applies (carry trade might suggest the opposite) then it implicitly suggests that in future the exchange rate may then slowly strengthen; to the extent this is recognised and thought implausible on fundamentals, the size of the initial fall may be larger with the predicted strengthening being due to a currency perceived as now being undervalued $\endgroup$ – Henry Jun 18 at 12:27
  • $\begingroup$ What are the other reasons for the weakening - if not increased money supply? Is buying govt. bonds causing "arbitrary reduction" in the interest rate? $\endgroup$ – Ajax Jun 18 at 14:26
  • $\begingroup$ If you are chasing yield, then you may move your savings from a now low-interest paying country to a higher-interest paying country. This can cause exchange rate movements (and the change in the two money supplies could even be the opposite of what you suggest). $\endgroup$ – Henry Jun 18 at 14:49
  • $\begingroup$ So in the short run the currency might weaken because people want to chases higher yields and so they will buy USD, but the interest rate arbitrage will disappear gradually through the passage of time, right? $\endgroup$ – Ajax Jun 18 at 15:23
  • $\begingroup$ That is the theory if uncovered interest rate parity applies, but it often may not. $\endgroup$ – Henry Jun 18 at 16:59
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Will this action [QE] tend to depreciate the country's currency against USD because money supply has increased decreasing the value of money?

There is considerable market folklore about this topic. However, from a fundamental basis, all QE represents is a change in the maturity structure of government liabilities. Long-term liabilities (bonds) are swapped for short-term liabilities (money). There is no good explanation as to why that would directly affect exchange rates (ignoring the interest rate effect, discussed next).

From interest rate parity, I believe it would follow that the currency would appreciate against the dollar. If yes, there are two opposing influences on the currency. Which one will prevail?

Interest rate parity is best thought of as an arbitrage condition: interest rate differentials plus the currency basis (which is a traded spread) determines forward rates. This is “covered interest parity”, and it holds (except perhaps in extremely stressed markets).

If interest rates fall due to QE - which is itself debatable - this implies strengthening forwards (assuming the basis does not move). This is necessary to equalise returns.

However, you are asking whether the spot exchange rate will strengthen. From a practical perspective, this is unlikely to even detectable.

  1. The belief that the spot exchange rate will follow forwards is a variant of the Efficient Market Hypothesis, and from what I have seen, this effect is either weak or non-existent. Feel free to search for “uncovered interest rate parity,” it is a large area of research.
  2. The strengthening of forwards is at the tenors associated with bonds. If a 10-year bond yield falls by 20 basis points due to QE, can we really tell whether the currency strengthened by 20 basis points per year over the next 10 years relative to its previous trajectory?
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  • $\begingroup$ Why is interest rates falling after QE debatable? If the central bank buys government bonds, won't their prices rise and yields fall? In QE, money supply increases. So won't money become cheap? I was asking whether the forward rate will strengthen by interest rate parity. It should, for a tenor, strengthen by just enough so as to eliminate currency arbitrage. The spot might not strengthen immediately. $\endgroup$ – Ajax Jun 18 at 14:30
  • $\begingroup$ My question is more about the two opposing influences on the value of the country's currency. Weakening influence because of the increased money supply, and strengthening influence with respect to the dollar because of low interest rates. Which of these effects prevails? $\endgroup$ – Ajax Jun 18 at 14:31
  • $\begingroup$ 1) Why is the effect of QE on bond yields debatable? There’s no good estimate of the effect. Supply/demand stories face efficient market arguments, which suggest zero effect. 2) There is no reason to believe that the movement of a forward rate moves the spot currency. 3) Which effect prevails? The theory is mixed, as I note. I am unaware of any strong empirical results. $\endgroup$ – Brian Romanchuk Jun 18 at 20:39

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