How do interest rates affect exchange rates? A complete guide

What are interest rates?

Let’s start with some basics. The interest rate is best described as the amount a lender charges a borrower. Not only does this tell you how high the cost of borrowing is, but also indicates what the rewards for saving are. 

As a borrower, this means that the interest rate is the amount you are charged for borrowing money – which will be shown as a percentage of the total amount of the loan. If the percentage is high, you will have more money to pay back.

However, as a saver, the interest rate gives you an indication of how much money will be paid into your bank account as a percentage of the amount of savings you have. The more savings you have, the more money you can expect to receive.

Interest rates can often fluctuate and have a big impact on both borrowers and savers. This is why it is important to always track percentage movements.

How does the interest rate affect the exchange rate?

As a general rule, the higher the interest rate, the more valuable a country’s currency is likely to be. This appreciation in the exchange rate is caused by a growth in demand for that particular currency, as higher interest rates will attract more foreign investment. Therefore, the value of a country’s currency will increase.

Alternatively, lower interest rates will decrease the currency’s value, as low-interest rates aren’t appealing to foreign investors.

When looking at how the interest rate affects the exchange rate, it’s not as simple as observing a correlation between the two. Several other factors will impact what might cause an exchange rate to fluctuate.

What factors impact interest rates?

While the main focus of this article is on how interest rates affect exchange rates, it’s important to understand the factors that impact interest rates in the first place. 

Demand for money

In a growing economy, money is more often than not in demand. This increase in the demand for money, or credit, will raise interest rates. However, when an economy isn’t doing so well, companies and individuals will avoid borrowing money if the demand for their products is low and money is tight.

Put simply, the less that people borrow will mean less demand for money, which will see a fall in interest rates.

Supply of money

The supply of money is obviously closely linked to the demand for money. In this instance, however, an increase in the supply of credit will reduce interest rates – while a decrease in the supply of credit will increase interest rates.

Inflation

The relationship between inflation and interest rates is very close and can be pretty complex. However, the higher the rate of inflation, the more interest rates are likely to rise. This is largely because savers will need to be compensated by higher interest rates when consumption motives are low during periods of high inflation. Similarly, investors will sacrifice their current consumption and invest in fixed-income investments.

Government borrowing

When government expenditure exceeds government revenue, it leads to a fiscal deficit. In order to fund this deficit, the government has to rely on borrowing. This obviously impacts the demand for money – which in turn will have an impact on interest rates. As a general rule, a high fiscal deficit will lead to more government borrowing, and this will result in higher interest rates. 

Global trade

High interest rates tend to bring in capital and support the foreign exchange rate. A country’s central bank may therefore opt to change interest rates to try and influence the exchange rate and give the economy a boost. In theory, higher interest rates should attract more foreign investment from abroad.

The balance of trade between a country’s imports and exports will have a big impact on currency value and the exchange rate. If there is greater demand for a country’s exports, then it means there will also be a demand for the country’s currency as well.

Other factors that impact exchange rates

When looking at how interest rates affect exchange rates, it’s also important to consider the other impacts that affect exchange rates. For a more in-depth look at this topic, we recommend you read our article: ‘What affects exchange rates and why do they change?’.

However, for a quick summary, we have listed the other main factors which affect exchange rates:

• Inflation – a country that is experiencing consistently low inflation will exhibit a rising currency value. However, a country with higher rates of inflation will see its currency depreciate.

• Public debt – if a country’s public deficit increases too much, then it will become less attractive to foreign investors. This will negatively impact the country’s currency value.

• Political stability – a stable country that has a responsible leader is more likely to attract foreign investment. 

• Terms of trade – if exports rise by a greater rate than imports, then a country’s terms of trade has improved. If this happens, it will lead to an increase in revenues and result in a higher demand for the country’s currency.

• Economic performance – quite simply, the more stable a country’s economy is, the more movement of capital to their currencies they’ll experience.

• Current account deficit – if a country is having to borrow foreign capital to bridge its deficit gap, then this demand for foreign currency will lower the exchange rate and devalue its currency.

• Speculation – if there is expected to be a rise in a country’s currency value, then this will attract more foreign investors.

Summary: How do changes in interest rates affect exchange rates?

Hopefully, you now understand a little more about how interest rates affect exchange rates. As we have mentioned, this relationship is far from simple, which is why we have included information in this guide about the other factors that impact both interest and exchange rates.

At WorldRemit, we want to make sure you’re able to manage your finances and send money internationally with confidence, which is why we recommend you check out our other supportive blogs and explore the useful resources we have listed at the bottom of this article.

How do interest rates affect exchange rates? FAQs

How do lower interest rates affect exchange rates?

Lower interest rates will reduce speculative demand for assets and therefore reduce demand for a currency. When interest rates are low, foreign investors will be put off from investing – which will ultimately weaken a country’s currency value. If interest rates are high, then it is likely that the opposite will happen.

Does raising interest rates make a currency stronger?

A country’s currency will rise in value when interest rates are high because higher rates will attract more foreign capital. This will lead to an increase in exchange rates and a strong currency. As a general rule, the higher the interest rates, the more foreign investment a country is likely to attract.

Why do high interest rates increase foreign investment?

In most cases, this will occur as a result of an increase in diversification opportunities to foreign investors seeking assets. The higher the interest rates, the more money they are likely to make on their assets. This will increase the attraction of these assets to a wider investor pool.

This communication is intended for marketing purposes only and does not constitute or provide legal, tax, investment or financial planning related advice.