MoneyMagpie

Oct 03

How interest rates affect exchange rates

Reading Time: 3 mins

An exchange rate refers to the rate one currency (e.g., US dollar or Australian Dollar) is exchanged for another. It’s also considered the relationship between one country’s currency value to another currency. An interest rate also refers to the interest amount due as a part of the borrowed, deposited, and lent amount in a time period.

In general, higher interest rates would increase a country’s currency value. On the other hand, lower interest rates are not good for foreign investment since it’ll decrease the relative value of a currency.

There are different factors impact exchange rates and currency value, one of which is the interest rate. Learn more about how interest rates can affect exchange rates by continue reading below.

 

Interest and Inflation Rates Affect Exchange Rates

Interest and inflation rates are closely related to each other, which can significantly influence exchange rates. There’s a complex relationship between the interest and inflation rates that’s usually difficult to manage.

Low-interest rates encourage economic growth and consumer spending, which positively influences currency value. It means that if there’s an increase in consumer spending wherein demand would exceed supply, inflation may ensue.

However, it doesn’t necessarily mean a negative outcome. Low-interest rates don’t always attract foreign investment. On the other hand, foreign investment can be attracted by higher interest rates, which increase the country’s currency demand.

Here are some takeaways when it comes to interest and inflation rates:

  • Interest and inflation rates influence exchange rates because they’re closely related to each other.

 

  • Aside from interest rates, the balance of trade, economic growth, and the debt level of the country influence currency value.

 

  • The currency’s perceived desirability is a powerful value determiner along with a nation’s exchange rate. That’s why it’s important to compare exchange rates when trading and doing business because the perceived desirability can be influenced by economic factors, like a nation’s economy and government stability.

 

  • The first consideration of investors is the security of holding cash in the currency as it is influenced by interest rates. This consideration is realized before determining potential profits.

 

  • If a country is economically or politically unstable, interest rates change. Also, there’s a significant possibility of devaluation or other currency value changes. If this condition happens, investors are reluctant to hold a large sum amount of cash and usually get away from the currency.

 

Interest Rates Affect Money Supply

Foreign investors always want to maximize their return on investment  (ROI). If you’re an investor, you should always seek to invest in securities offering the highest yield. Of course, you want investments with the lowest risk possible.

When the supply of money increases, foreign money will experience outflow. It’s because of the falling interest rates with falling yields. Now, if the Central Bank won’t intervene or take action in the foreign exchange market, there will be a domestic currency depreciation.

On the other hand, if the Central Bank reduces the money supply, the interest rates rise and so as the yields, which would prompt the domestic economy to pour money. If this situation happens, there will be an appreciation in the value of a domestic currency relative to other currencies.

That’s why checking the NAB exchange rates is crucial to have an idea of how interest rates can affect exchange rates.

 

Interest Rate Hike

The relationship between exchange rate and interest rates have a huge impact on economies. For instance, the United State’s interest rate hike affects developing countries’ exchange rates, say India. It’s because investors tend to withdraw money from India and put it in the securities of the United States.

A low domestic exchange rate is crucial for economies that are export-oriented to ensure that they have more affordable exports as compared to their competitors. Countries can meddle on the foreign exchange market (keeping a narrow band exchange rate) or fix the exchange rate. That’s when Central banks can use their freedom to hike or cut the interest rates in order to maintain a desirable exchange rate that could cause the greatest benefit.

As previously mentioned, an interest hike imposed by the Central Bank will lead to domestic currency appreciation as the economy offers a risk-free rate yield. If there’s a money supply expansion, it’ll lead to domestic currency depreciation when the domestic economy bears less attractive risk-free rate yield.

 

Conclusion

Generally, the relationship between exchange rates and interest rates is in a floating regime. Interest rates have a major impact on exchange rates. With the combination of inflation, demand and supply of money, banking actions, and investors’ actions interest rates may rise or decline, which can also significantly affect exchange rates.

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