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Several related elements determine a currency’s exchange rate.

In general, higher interest rates in one country tend to increase the value of its currency. Higher interest rates also tend to attract foreign investors, thus increasing demand for the domestic currency. But there’s a lot more to it.

The relationship between higher interest rates and inflation complicates matters. When interest rates in a country rise, inflation often follows, and higher inflation tends to decrease a currency’s value. If a country can increase interest rates without increasing inflation, its currency’s value and exchange rates are likely to rise as well.

Political and economic stability, and the demand for a country’s goods and services, are important, too. When there’s greater demand for a country’s goods, there will be greater demand for its currency. Analysts and investors consider a nation’s gross domestic product and trade balance when evaluating its currency. They also look at debt, because high levels will lead to higher inflation rates, and possibly a currency devaluation.

As U.S. government and consumer debt has skyrocketed in recent years, the Federal Reserve has kept interest rates near zero. Still, the U.S. dollar generally enjoys favorable exchange rates, partially because it is the reserve currency for much of the world, and is perceived as a safe haven. When determining the value of the U.S. dollar, these factors have trumped inflation and other considerations.

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