How Do Interest Rates Affect Exchange Rates?

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Interest rates influence exchange rates because they directly affect the supply and demand of a nation’s currency. Fluctuating interest rates affect currency values in a directly proportionate manner. Higher interest rates provide lenders a higher return relative to other nations; higher returns attract foreign capital, which increases demand and causes the exchange rate to rise. The opposite is true for decreasing interest rates, which proportionately decreases exchange rates.

A country’s central bank exerts influence over exchange rates by setting interest rates and subsequently controlling monetary policy. The primary influence that drives exchange rates is interest-rate changes made by any of the eight global central banks. These banks increase interest rates to curb inflation and cut rates to promote lending and inject money into their economies.

Unexpected increases in the interest rate in the United States relative to overseas would provide investors a higher return on U.S. assets relative to their foreign equivalents. This raises the value of the dollar, reduces the price of imports and reduces demand of U.S. goods and services abroad.

Exchange rates are relative because they are a comparison of the currencies of two countries. Several factors determine exchange rates, but all are related to the economies and trading relationship between the two countries. Interest rates provide a scale for the cost of borrowing or the gain from lending.