The relationship between the interest rate and the exchange rate is a significant determinant of a country’s economic health. Moreover, exchange rates can influence a country’s level of trade, making it the most analyzed and manipulated economic factor.
For years, economists and policymakers have debated how interest rates and exchange rates relate. However, it may still be tricky for some to understand how the factors affect the economy. The good news is, this guide will cover all the facts about the two factors.
That said, let’s get started.
While interest rates and exchange rates don’t have direct one-on-one relationships, they impact each other in many ways. As a result, it can influence the value of a country’s currency. Interest rates can make a currency more or less valuable against others.
So, how do interest rates affect the value of a currency?
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A high interest rate in a country shows that its currency is more valuable than currencies in countries that offer low interest rates. So, from a foreigner’s perspective, investing or saving in a country with high interest rates will most likely bring higher returns.
As a result, that would raise the demand for the country’s currency. Foreign investors will take advantage of the increased interest rates and move their investments or funds to the country. As the currency’s demand rises, it becomes stronger and appreciates.
The strengthening of a currency relative to another currency will improve its exchange rate. As a result, this would be good news for importers in the country and unfortunate news for exporters. That’s because importing goods is relatively cheaper than exporting.
When a country has low interest rates, its currency becomes less valuable than other countries with higher interest rates. For that reason, many foreign investors will shy from saving money or investing in the country. So, their investments would yield low returns.
When the foreigners stay away from the country’s market, the demand for its currency will fall. As a result, the money would depreciate in the foreign exchange market, making the exchange rate weaker than countries with stronger currencies.
Importing goods from a country with a stronger currency to a weaker one would be more expensive. Also, currency depreciation will make exports more competitive in a country with a weak currency. That can even result in economy-wide inflation.
Pro Tip: While interest rates are vital factors affecting a currency’s value and exchange rates, other related elements will set the final exchange rate relative to other currencies. Such features reflect a country’s overall financial condition compared to other nations.
Now that you understand the relationship between an interest rate and exchange rate, it is also essential to know how both factors relate to inflation. The truth is that inflation, interest rates, and exchange rates are strongly correlated.
When a central bank manipulates interest rates, it exerts pressure on inflation and the exchange rates. Consequently, the dynamic interest rates will influence inflation and currency values. So, how do interest rates affect inflation and exchange rates?
An economy with high interest rates provides lenders with a higher return than countries with lower interest rates. As a result, the higher interest rates will attract more foreign capital and increase exchange rates.
However, higher interest rates become less significant when inflation in the country is higher than in other countries. This is because high inflation reduces the purchasing power of the country’s currency, causing its exchange rates to fall.
Lower interest rates tend to encourage consumer spending and economic growth. As a result, this would positively influence a country’s currency value. However, if consumer spending increases until demand exceeds supply, the country can experience inflation.
When inflation rises due to increased consumer spending, it harms a currency’s value and exchange rate. In other words, a lower interest rate can result in a high inflation rate, which can result in a lower exchange rate.
Note that inflation is closely related to interest rates, which can affect exchange rates. So, the three factors are associated with each other. Most countries strive to balance inflation and interest rates. However, the relationship between the two is complicated.
Other factors determine a country’s interest rates, including the decisions made by central banks, currency supply and demand, and government spending.
Here is how each factor will affect the interest rates.
In any country, the central bank has the key policy rate, which is the interest rate banks charge on loans. In turn, the rate affects interest financial institutions like banks charge borrowers. Canada’s central bank is the Bank of Canada.
When the Bank of Canada increases the interest rates, the cost of borrowing money increases. As a result, it discourages firms and people from borrowing. However, more people are likely to borrow funds when the interest rates get lowered.
Since borrowing becomes more expensive when the interest rate is high, the demand for money will fall. If the Bank of Canada wants to encourage economic growth, it may lower the interest rates, which will result in an increased supply of money. As a result, borrowing will be less expensive. Raising interest rates will decrease the money supply.
Excessive spending by the government can lower the funds available for consumers and businesses that want to borrow funds. That makes loans more expensive, raising the interest rates. If the government’s debt is too high, it can borrow more money from the central bank or foreign allies to maintain the value of its currency.
Whether you are a borrower, lender, or forex trader, the following tips will help you take full advantage of the fluctuations in interest rates.
Are you a lender or a borrower? When the domestic interest rates rise, it will be an advantage to lenders and a disadvantage to borrowers. All credit card payments and loans will be expensive. For that reason, you should borrow less money.
However, when the interest rates go down, you can go for short-term loans and use your credit card comfortably since the repayment burden will be too low. Notably, higher interest rates can make investments more attractive and profitable for lenders.
When the interest rates are high, most consumers and businesses tend to cut back on spending. As a result, the companies will turn to the market and borrow to release more equity, lowering the stock prices. Thankfully, this would be the best time to buy stocks.
When the interest rates fall, businesses will turn their attention to debt financing and not equity financing. So, they will borrow less from the market and more from banks. As a result, the stock prices will rise, making it the best time to sell your stocks and earn.
Both interest rate and exchange rate are interdependent in determining a currency’s value. Moreover, inflation can also influence exchange rates since it is closely related to interest rates. Notably, the central bank, such as the Bank of Canada, plays a crucial role in setting interest rates for banks and other financial institutions in the country.
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