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. 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 >>
  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 the difference between a nation's current account deficit and its currency ...

    Learn the respective meanings of the two terms, current account deficit and currency valuation, and understand the relationship ... Read Answer >>
  4. What are key benefits to a country that has engaged in a policy of currency depreciation?

    Learn about key benefits to a country engaging in a policy of currency depreciation, such as smaller trade deficits, employment ... 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

    Drastic Currency Changes: What's The Cause?

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

    The U.S. Dollar: What Every Forex Trader Needs To Know

    The U.S. dollar is by far the most significant currency in the global market. Find out what you need to know if you want to trade it.
  4. Trading

    The 6 Most-Traded Currencies And Why They're So Popular

    Every currency has specific features that affect its underlying value and price movements in the forex market.
  5. Investing

    Profit From Forex With Currency ETFs

    There's always a bull market somewhere - and now you can find it with currency ETFs.
  6. Trading

    Using Interest Rate Parity To Trade Forex

    Learn the basics of forward exchange rates and hedging strategies to understand interest rate parity.
RELATED TERMS
  1. International Currency Exchange Rate

    An international currency exchange rate is the rate at which ...
  2. Currency

    Currency is a generally accepted form of money, including coins ...
  3. Currency ETF

    Currency ETFs aim to replicate movements of a single currency ...
  4. Currency Board

    A currency board is a monetary authority that makes decisions ...
  5. Trade Surplus

    An economic measure of a positive balance of trade, where a country's ...
  6. Currency Pairs

    Two currencies with exchange rates that are traded in the retail ...
Hot Definitions
  1. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  2. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  3. Risk Tolerance

    The degree of variability in investment returns that an individual is willing to withstand. Risk tolerance is an important ...
  4. Donchian Channels

    A moving average indicator developed by Richard Donchian. It plots the highest high and lowest low over the last period time ...
  5. Consumer Price Index - CPI

    A measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, ...
  6. Moving Average - MA

    A moving average (MA) is a widely used indicator in technical analysis that helps smooth out price action by filtering out ...
Trading Center