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 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 >>
  3. 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 >>
  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 >>
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. Investing

    Why Countries Keep Reserve Currency

    Central banks and financial institutions hold large amounts of foreign money as their reserve currency.
  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

    Drastic Currency Changes: What's The Cause?

    Currency fluctuations often defy logic. Learn the trends and factors that result in these movements.
  7. 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.
  8. Trading

    Understanding the Floating Exchange Rate

    Floating exchange rate is the exchange rate between two currencies at any given time.
  9. Trading

    Top 5 Hardest-Hit Currencies

    The value of a country's currency is dependent on many factors that will cause it to fluctuate, relative to other world currencies.
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. Soft Currency

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

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

    The ratio at which one currency can be exchanged for another. ...
  6. Currency Substitution

    The use of a foreign currency in transactions in place of the ...
Hot Definitions
  1. Gross Margin

    A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
  2. Current Ratio

    The current ratio is a liquidity ratio measuring a company's ability to pay short-term and long-term obligations, also known ...
  3. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
  4. Quantitative Easing

    An unconventional monetary policy in which a central bank purchases private sector financial assets in order to lower interest ...
  5. Risk Averse

    A description of an investor who, when faced with two investments with a similar expected return (but different risks), will ...
  6. Indirect Tax

    A tax that increases the price of a good so that consumers are actually paying the tax by paying more for the products. An ...
Trading Center