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I understand that Federal bank/Goverment can manipulate the currency market and devalue its currency by printing more money or buying foreign currencies/assets (essentially increasing the supply of home country's currency). Devaluation eventually leads to cost-push/demand-pull inflation (not necessarily though, for eg: in times of recession, this might not happen). To combat inflation, interest rate would need to increase.

However, on the other hand, another theory states that - lower interest rates gives rise to inflation and eventually leads to currency devaluation.

What I cannot get my head around is what is the cause and what is its effect? Or do they function in sync and are basically two different tools of goverment to maintain the balance and control the economy?

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  • $\begingroup$ Central bank cannot devalue it’s currency by printing more money or changing interest rate. That is incorrect, you are most likely confusing devaluation with depreciation. Devaluation is change of fixed exchange rate by decree that in principle does not need to be accompanied by any other action. $\endgroup$ – 1muflon1 Jul 14 at 16:40
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  • The bond market is a market, albeit following the lead of the central bank at the short end.
  • The currency market is a market.
  • The simplest and crudest version of the Efficient Markets hypothesis is that it is difficult to “beat a market” using a simple rule. The argument is that if such a simple rule exists, everyone would do it, causing prices to shift. (There can be regularaties like the term premium - bonds tend to outperform cash in the long run - but one needs to take risk exposures to achieve such gains.)

Taken together, the previous statements suggest that there should be no simple relationship between interest rates and currencies. If the previous logic is incorrect and such a relationship exists, feel free to use it to make a fortune as a currency strategist. (Disclaimer: this is not a recommendation to trade currencies without understanding the risks involved.)

Textbooks love discussing interest rate parity relationships. This is an arbitrage relationship used to pin down the pricing of currency forwards. However, the predictive power of forwards is at best weak, leaving us back near the possibility of efficient markets.

Finally, the exception to the bond and currency markets is the possibility of a pegged currency, or pegged bond yields (relatively rare). At which case, one needs to look at the behaviour of currency pegs, and runs on such pegs.

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