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 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 the overall financial condition of a country in respect to other nations.

Generally, higher interest rates increase the value of a country's currency. Higher interest rates 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.

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 relationship that exists between higher interest rates and inflation. If a country can achieve a successful balance of increased interest rates without an accompanying increase in inflation, its currency's value and exchange rate is more likely to rise.

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

Another important factor is a country's level of debt. High levels of debt, while manageable for shorter time periods, eventually lead to higher inflation rates and may ultimately trigger an official devaluation of a country's currency.

The recent history of the U.S. clearly illustrates the critical importance of a country's overall perceived political and economic stability in relation to its currency valuations. As U.S. government and consumer debt has risen, the Federal Reserve has moved to maintain interest rates near zero in an attempt to stimulate the U.S. economy. The Fed has since moved to incrementally raise interest rates to 1.50% (as of February 2018) in response to a recovering economy, but rates are still very low compared to pre-financial crisis levels.

Even with historically low interest rates, 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 factor, even more so than interest rates, inflation or other considerations, has proven to be significant for maintaining the relative value of the U.S. dollar.

RELATED FAQS
  1. How are international exchange rates set?

    Knowing the value of your home currency in relation to different foreign currencies helps investors to analyze investments ... Read Answer >>
  2. 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 >>
  3. How does the balance of payments impact currency exchange rates?

    Take a brief look at the relationship between a nation's balance of payments and the exchange rate value of its currency ... Read Answer >>
Related Articles
  1. Investing

    The Pros And Cons Of A Pegged Exchange Rate

    A pegged exchange rate occurs when one country fixes its currency’s value to the value of another country’s currency. But it has both pros and cons.
  2. Investing

    Protect your foreign investments from currency risk

    Hedging against currency risk can add a level of safety to your offshore investments.
  3. Trading

    8 Basic Forex Market Concepts

    We go over some of the things you need to understand before you can trade currencies.
  4. Trading

    Understand the Indirect Effects of Exchange Rates

    Exchange rates have a tremendous influence on the economy. Exchange rates can indirectly affect many of the most important aspects of our lives.
  5. Investing

    What Is A Currency War And How Does It Work?

    We look at what a currency war is, what factors may lead to it, the impacts of such a strategy, and whether there is a currency war currently.
  6. Trading

    Profiting From a Weak U.S. Dollar

    Learn how to allocate your investments when the U.S. dollar is down.
  7. Trading

    Top 5 Reasons To Invest In Currencies

    Here's why you should get into the forex market.
  8. Insights

    10 Countries With Lower Interest Rates Than the US

    Learn about the 10 countries with lower interest rates than the United States and how interest rates indicate a country's economic outlook.
RELATED TERMS
  1. International Currency Exchange Rate

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

    A national currency is a legal tender issued by a central bank ...
  3. Currency ETF

    Currency ETFs (exchange-traded funds) aim to replicate movements ...
  4. Currency Appreciation

    Currency appreciation is an increase in the value of one currency ...
  5. Exchange Rate

    An exchange rate is the price of a nation’s currency in terms ...
  6. Managed Currency

    A managed currency is one whose monetary exchange rate is affected ...
Hot Definitions
  1. Business Cycle

    The business cycle describes the rise and fall in production output of goods and services in an economy. Business cycles ...
  2. Futures Contract

    An agreement to buy or sell the underlying commodity or asset at a specific price at a future date.
  3. 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 ...
  4. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  5. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  6. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
Trading Center