Causes of foreign exchange rate fluctuations: changes in the interest rate

International Trade & Globalisation – Foreign Exchange Rates

Objective: How Interest Rate Changes Affect FX Rates

💰 Interest rates are like the price tag on borrowing money. When a country raises its rates, borrowing becomes more expensive but investing becomes more attractive. This can change how much people want the country’s currency, which in turn changes its value against other currencies.

🔍 Key idea: If the domestic interest rate is higher than a foreign rate, the domestic currency usually appreciates (gets stronger). If it is lower, the currency usually depreciates (gets weaker).

📈 Interest‑rate parity shows the relationship mathematically:

$$\frac{S_1}{S_0} = \frac{1 + i_{\text{domestic}}}{1 + i_{\text{foreign}}}$$

Where $S_0$ is the current spot rate, $S_1$ the future spot rate, $i_{\text{domestic}}$ the domestic interest rate, and $i_{\text{foreign}}$ the foreign rate.

Why Do Rates Matter?

• Higher rates attract foreign investment because investors get better returns.
• More investors need the domestic currency to buy local assets, increasing its demand.
• Increased demand pushes the currency’s value up (appreciation).
• Conversely, lower rates make the currency less attractive, reducing demand and causing depreciation.

Real‑World Example: Australia vs. the United States

When the Reserve Bank of Australia (RBA) raises rates from 2.5% to 3.5%, the Australian dollar (AUD) tends to strengthen against the USD because investors want the higher return on Australian assets.

Step‑by‑Step: From Rate Change to Currency Move

1. Central bank announces a rate hike (e.g., from 2.0% to 2.5%).
2. Investors notice the higher return on domestic bonds.
3. They buy more domestic bonds, needing the domestic currency to do so.
4. Demand for the currency rises, pushing its price up against foreign currencies.
5. The currency appreciates, making imports cheaper but exports more expensive.

Quick Check: What Happens if Rates Fall?

• Lower rates reduce the return on domestic assets.
• Investors shift to higher‑yielding foreign assets.
• Demand for the domestic currency falls.
• The currency depreciates, making exports cheaper and imports more expensive.

Takeaway

📌 Interest rate changes are a powerful driver of foreign exchange rates. Think of them as the “fuel” that moves the currency market: higher rates fill the tank, pulling the currency up; lower rates drain it, letting the currency slip down.