Here is the argument as presented by CNBC and Bloomberg (and most Central Bankers):

1. The exchange rate is plummeting!
2. Therefore, we must raise interest rates.

Happily, I can say that I understand the logic (it’s taken me a while). But I feel like I’m in the minority – mainly because there is a whole story between 1 and 2 that gets treated as “assumed knowledge”.

So this post is an explanation (and, in all likelihood, a criticism – but to be honest, as I haven’t gotten to the end yet, I don’t know how it will end).

The Exchange Rate/Interest Rate Theory

Welcome to the world of “interest rate parity”. If you ask an economist what the relationship is between exchange rates and interest rates, you will almost always get this:

Which is unpleasant, because an equation might be a concise expression of a concept, but it requires you to pay attention to ns and is and Ss.

So let me try and explain this by getting drunk:

1. You walk into a bar.
2. Because you’re a man’s man, you’re partial to both pilsener draught and a few drams of Johnny Black.
3. Whisky has an alcohol content of 40%.
4. Beer has an alcohol content of 5%.
5. If you’re aiming to get to merry, you’d be able to take 8 sips of beer for every sip of whiskey.
6. So you could establish some kind of equilibrium exchange rate between the two drinks (either 8 millilitres of beer or one millilitre of whiskey will get you to the same state in the same amount of time).

Then let’s say that someone comes in, and tells you that the beer brewers have decided to up the alcohol content of their beer to 10% (perhaps to keep up with the Stella competition). Now – now you only need to take 4 sips of beer for every sip of whiskey.

What should happen?

Well, assuming that we all just want to get liquored and we don’t really mind how, we’ll all start moving across to the pilsener and drinking less of the Johnny. The price of pilsener would get driven up, and the price of Johnny would sink down. So:

1. If you’re a whiskey man, the relative value of your dram has dropped from 8 beer mils per whiskey mil down to 4.
2. If you’re a beer man, the relative value of your draught has increased from 0.125 whiskey mils per beer mil up to 0.25.

And in case it’s not clear: the alcohol content is representative of interest rates, and the exchange rate is the point at which you’d be ambivalent between drinking whiskey and drinking beer.

Bringing It Back To Economics

So currencies work in much the same way. Interest rates represent the “price” of the currency (where time is money). And if one country is offering to pay you more for holding theirs, then you’d move across to their currency until the rising cost of that currency (relative to the one you initially hold) makes you ambivalent between the two.

However*.
*Isn’t there always one?

Not all drinkers drink to get drunk. Alcohol works differently if you’re ill, or if you’re fit, or if you’re taking antibiotics. Some forms make you more aggressive that others. Gin makes me mellow.

That aside, it’s important to remember that perception is important (if not all-important). And if everyone thinks that the interest rate is important, then it is. Here is the 30 day graph of the exchange rate between the Turkish Lira and the US Dollar:

That sudden spike would be the surprise interest rate increase from 4.5% to 10% (and for an explanation of how changes in interest rate affect you, read this post).

So now you know.