How Do National Interest Rates Affect a Currency's Value and Exchange Rate?

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 rises, the Federal Reserve movers to maintain interest rates near zero in an attempt to stimulate the U.S. economy. When the economy recovers and grows, the Fed responds by incrementally raising interest rates.

Even with historically low interest rates, the U.S. dollar still enjoys 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.