How are currencies and exchange rates affected by interest rates?
All other factors being equal, higher interest rates in a country increase the value of that country's currency relative to countries offering lower interest charges per unit.
All the same, such simple straight-line calculations rarely exist in foreign exchange.
Although interest rates can be a major factor influencing currency value and exchange rates,
the final decision of a currency's exchange rate with other currencies is the outcome of a number of interconnected factors that reflect the overall fiscal condition of a country with regard to other countries.
• The value of a country's currency increases with higher interest rates compared to countries that offer lower interest rates
• Political and economic stability and the requirement for a country's goods and services are also prime factors in currency valuation.
Factors in Currency Values
Broadly speaking, higher interest rates increase the value of a country's currency.
Higher interest rates tend to draw foreign investment, increasing the demand for and value of the home country's currency.
On the contrary, lower interest rates tend to be unattractive for foreign investment and decrease the currency's relative value.
This simple natural event is complicated by a horde of other elements that impact currency value and exchange rates.
Unmatchable of the main complicating factors is the relationship that exists between higher interest rates and rising prices.
If a nation can achieve a successful balance of increased interest rates without accompanying growth in inflation, its currency's value and exchange rate are more potential to develop.
Interest rates alone do not set the value of a currency.
Two other factors—political and economic stability and the requirement for a country's goods and services—are often of greater importance.
Elements such as a country's balance of trade between imports and exports can be a crucial element in determining currency value.
That is because greater demand for a country's products means a greater need for the country's currency as well.
Convenient numbers, such as GDP (the gross domestic product) and balance of trade are also key figures that analysts and investors consider in assessing a given currency.
Another factor is the level of debt of the country.
High levels of debt, while manageable for shorter time periods, eventually go to higher inflation rates and may finally trigger an official devaluation of a country's currency.
Government, Politics, Economics, and Currency Valuation
The recent history of the U.S. clearly illustrates the critical importance of a country's overall perceived political and economic stability in relation to its currency valuations.
As the U.S. government and consumer debt rise, the Federal Reserve movers to maintain interest rates near zero in an attempt to stimulate the U.S. economy.
When the economy recovers and grows, the Fed responds by incrementally raising interest rates.
Even with historically low interest rates, the U.S. dollar still enjoys favorable exchange rates in relation to the currencies of most other nations.
This is partially due to the fact that the U.S. remains, at least to some extent, the position of being the reserve currency for much of the world.
Likewise, the U.S. dollar is still perceived as a secure harbor in an economically uncertain world.
This element—even more so than interest rates, inflation, or other considerations—has turned out to be important for maintaining the proportional value of the U.S. dollar