How Interest Rates Affect Foreign Exchange

Interest rates are something that drives the foreign exchange market. The interest rate influences the exchange rate because it influences the demand and supply of currencies on the foreign exchange markets. While currency prices are what the market is all about, interest rates have a direct affect on those prices. Therefore, to be able to understand the current foreign exchange market, one must understand the current conditions of each individual interest rate.

An interest rate is the price a borrower pays for the use of money they do not own. It is normally expressed as a percentage rate over the period of one year. Interest rates are the main determinant of investment on a macroeconomic scale. Broadly speaking, if interest rates increase across the board, then investment decreases, causing a fall in national income. A government institution, usually a central bank, can lend money to financial institutions to influence their interest rates as the main tool of monetary policy. Usually central bank interest rates are lower than commercial interest rates since banks borrow money from the central bank then lend the money at a higher rate to generate most of their profit. By altering interest rates, the government institution is able to affect the interest rates faced by everyone who wants to borrow money for economic investment.

Interest rate decision, announced by the central bank of the country, tends to affect the exchange rate. If the central bank is hawkish about the inflationary outlook of the economy and rises the interest rates it is positive, or bullish, for the currency of the economy. Likewise, if the central bank has a dovish view on the economy and keeps the ongoing interest rate, or cuts the interest rate it is seen as negative, or bearish.

Interest rate has a very strong impact on a country’s currency exchange. Now if the interest rate of a country rises, the demand of that country’s currency goes up and its value gets appreciated and vice versa. Something to remember is that money often follows interest rates. When the interest rates raise, investors will want to capitalize high returns and you will see money flowing into the country. When one country’s interest rates rise, their currency is seen as being stronger than other currencies. This happens because investors seek more of that currency to profit more. Otherwise, it is seen as a good thing when interest rates rise and a bad thing when they fall.

While interest rates can drive the market for a short time, the nature of the foreign exchange market makes it difficult for them to drive it for a long period of time. The design of the market, with it being large in size and volume, restricts interest rates from having complete control over the system. Many times however, experts try to figure out when interest rates will rise or fall. The most common thing they do in order to keep up with rates is to pay attention to economic inflation indicators.

As you can see, the influences of interest rates on the foreign exchange market are strong. They can help determine which countries’ currencies are the strongest. This of course is relative to all other currencies in the market at the time. When you think about the rise and fall of interest rates, you can remember that when interest rates fall, it is typically a good thing for investors and for domestic currency. When rates fall, it is not such a great thing. When rates stay low for an extended period of time, the market may seem a little dull, however the great thing about the foreign exchange market is that when government gets involved, which it usually does at these down times, there is hope for improvement.