Loading the player...
A:

All other factors being equal, higher interest rates in a country increase the value of that country's currency relative to nations offering lower interest rates. However, such simple straight-line calculations rarely, if ever, exist in foreign exchange. Although interest rates can be a major factor influencing currency value and exchange rates, the final determination of a currency's exchange rate with other currencies is the result of a number of interrelated elements that reflect and impact the overall financial condition of a country in respect to that of other nations.

Generally, higher interest rates increase the value of a given country's currency. The higher interest rates that can be earned tend to attract foreign investment, increasing the demand for and value of the home country's currency. Conversely, lower interest rates tend to be unattractive for foreign investment and decrease the currency's relative value.

However, this simple occurrence is complicated by a host of other factors that impact currency value and exchange rates. One of the primary complicating factors is the interrelationship that exists between higher interest rates and inflation. If a country can manage to achieve a successful balance of increased interest rates without an accompanying increase in inflation, then the value and exchange rate for its currency is more likely to rise.

Interest rates alone do not determine the value of a currency. Two other factors that are often of greater importance are political and economic stability and the demand for a country's goods and services. Factors such as a country's balance of trade between imports and exports can be a much more crucial determining factor for currency value. Greater demand for a country's products means greater demand for the country's currency as well. Favorable gross domestic product (GDP) and balance of trade numbers are key figures that analysts and investors consider in assessing the desirability of owning a given currency.

Another important factor is a country's level of debt. While they can be managed for some period of time, high levels of debt eventually lead to higher inflation rates and may ultimately trigger an official devaluation of a country's currency.

The recent history of the United States clearly illustrates the critical importance of a country's overall perceived political and economic stability. In recent years, U.S. government and consumer debt has exploded to new high levels. In an attempt to stimulate the U.S. economy, the Federal Reserve has maintained interest rates near zero. Despite these facts, the U.S. dollar has enjoyed favorable exchange rates in relation to the currencies of most other nations. This is partially due to the fact that the U.S. retains, at least to some extent, the position of being the reserve currency for much of the world. Also, the U.S. dollar is still perceived as a safe haven in an economically uncertain world. This fact, more so than interest rates, inflation or other considerations, has proven to be the overriding and determining factor for the relative value of the U.S. dollar.

RELATED FAQS
  1. How does inflation affect the exchange rate between two nations?

    Inflation is closely related to interest rates, which can influence exchange rates. Countries attempt to balance interest ... Read Answer >>
  2. What economic indicators are most used when forecasting an exchange rate?

    Discover what economic indicators are most widely used to forecast a country’s exchange rate and how various factors influence ... Read Answer >>
  3. What is foreign exchange?

    Foreign exchange, or Forex, is the conversion of one country's currency into that of another. In a free economy, a country's ... Read Answer >>
  4. How are international exchange rates set?

    International currency exchange rates display how much one unit of a currency can be exchanged for another currency. Currency ... Read Answer >>
  5. What are key economic factors that can cause currency depreciation in a country?

    Read about the causes of currency devaluation, and find out how to differentiate between relative and absolute currency devaluation. Read Answer >>
Related Articles
  1. Trading

    Interest Rate and Currency Value And Exchange Rate

    In general, higher interest rates in one country tend to increase the value of its currency.
  2. Trading

    6 Factors That Influence Exchange Rates

    An in depth look at out how a currency's relative value reflects a country's economic health and impacts your investment returns.
  3. Trading

    Main Factors that Influence Exchange Rates

    The exchange rate is one of the most important determinants of a country's relative level of economic health and can impact your returns.
  4. Investing

    Explaining Fixed Exchange Rates

    A government using a fixed exchange rate has linked the value of its currency to the value of another country’s currency, or the price of gold.
  5. Trading

    What Happens in a Currency Crisis?

    A currency crisis comes from a decline in the value of a country’s currency.
  6. Trading

    How Are International Exchange Rates Set?

    International exchange rates show how much one unit of a currency can be exchanged for another currency.
  7. Trading

    Drastic Currency Changes: What's The Cause?

    Currency fluctuations often defy logic. Learn the trends and factors that result in these movements.
  8. Trading

    Top Economic Factors That Depreciate The $US

    A variety of factors contribute to currency depreciation, including monetary policy, inflation, demand for currency, economic growth and export prices.
  9. Trading

    The Effects Of Currency Fluctuations On The Economy

    Currency fluctuations are a natural outcome of the floating exchange rate system that is the norm for most major economies. The exchange rate of one currency versus the other is influenced by ...
RELATED TERMS
  1. International Currency Exchange Rate

    The rate at which two currencies in the market can be exchanged. ...
  2. Funding Currency

    The currency being exchanged in a currency carry trade. A funding ...
  3. Currency Appreciation

    An increase in the value of one currency in terms of another. ...
  4. Soft Currency

    A currency with a value that fluctuates as a result of the country's ...
  5. Currency

    Currency is a generally accepted form of money, including coins ...
  6. Conversion Rate

    The ratio at which one currency can be exchanged for another. ...
Hot Definitions
  1. Fixed-Income Security

    An investment that provides a return in the form of fixed periodic payments and the eventual return of principal at maturity. ...
  2. Free Cash Flow - FCF

    A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents ...
  3. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to ...
  4. Two And Twenty

    A type of compensation structure that hedge fund managers typically employ in which part of compensation is performance based. ...
  5. Market Capitalization

    The total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying ...
  6. Expense Ratio

    A measure of what it costs an investment company to operate a mutual fund. An expense ratio is determined through an annual ...
Trading Center