Economics – International trade and globalisation - Foreign exchange rates | e-Consult

Changes in a country's interest rate have a significant impact on its foreign exchange rate. This relationship is primarily driven by the concept of capital flows. When a country increases its interest rate, it becomes more attractive to foreign investors seeking higher returns. This increased demand for the country's assets (e.g., bonds, stocks) leads to an increase in demand for its currency.

Increased demand for the currency causes its value to appreciate – meaning it becomes more expensive to buy. Conversely, if a country lowers its interest rate, its assets become less attractive to foreign investors. This reduces demand for the currency, leading to depreciation.

Example: Consider the UK and the US. If the Bank of England increases interest rates while the Federal Reserve keeps its rates unchanged, investors will likely shift capital from the US to the UK to take advantage of the higher returns. This increased demand for the pound sterling (GBP) will cause the GBP/USD exchange rate to appreciate. Similarly, if the Federal Reserve lowers interest rates, capital may flow from the UK to the US, causing the USD to appreciate against the GBP.

Factors influencing the magnitude of the effect:

• Relative Interest Rates: The difference in interest rates between two countries is crucial.
• Investor Confidence: Overall economic stability and investor confidence play a role.
• Risk Appetite: Investors' willingness to take risks influences capital flows.