At a basic level, higher interest rates tend to lead to an appreciation in the value of a currency. In turn, the exchange rate is affected as the value of a currency increases in relation to others.
Interest Rates Help to Determine the Value of a Currency
Interest rates are a key factor in determining the value of a currency. If it were possible to remove all of the other elements that contribute to the value of a currency, an increase in the interest rate would cause the value of a currency to rise. Essentially, this is because higher interest rates in a particular currency offer investors (those who buy a currency) a higher return relative to other currencies.
In an idealised example, when interest rates rise, investors are attracted to a currency and invest in it more heavily. As more investors are attracted, demand for the currency increases, and its value goes up.
These flows of investment are known in economics as ‘hot money flows’.
The opposite relationship is true for decreasing interest rates. That is, lower interest rates tend to decrease the value of a currency.
But There are Other Things to Consider…
However, while interest rates are a key factor in determining the value of a currency, the impact of a rise in interest rates is reduced if inflation levels are too high or if other factors lower the value of a currency.
In reality, the factors which influence the value of a currency at any particular moment are highly complex. While interest rates are a key part of the equation and while the effect of a change to interest rates is often immediately noticed in exchange rates, the overall number of factors that affect exchange rates is highly complicated.
Importantly, increases in interest rates are associated with higher levels of inflation which can cause the value of a currency to fall. In order for a currency to rise in value from an increase in interest rates, it is necessary for a country to strike a balance between interest rates and levels of inflation.
The central problem is that while higher interest rates will cause in an increase in value for an investor in a currency over time if there is an accompanying increase in inflation this will also cause a decrease in value.
Where inflation occurs in a country, the value of the goods it produces increases. This in turn will cause a decrease in foreign demand for those goods. Overseas buyers will then buy less of those goods, causing a decrease in demand for the currency and a fall in its value.
Whether or not a currency is a good investment over time actually depends on both interest rate and the rate of inflation. It is usually necessary to look at both before determining whether an investment will grow over time.
General Economic Health and Stability of a Country
The other important thing to consider is that interest rates and rates of inflation are only two factors in a much wider landscape. Ultimately, the number of factors that influence the value of a currency is very large and certain currencies enjoy a favourable rate of exchange for reasons other than the interest rates they have.
In some cases, currencies enjoy a favourable exchange rate in spite of having low-interest rates. The euro, for example, despite having very low-interest rates since 2008 (they have been negative for much of that period), has had very favourable exchange rates against many of the world’s currencies.
Some of the main things which influence the general economic health and stability of a currency are…
The Balance of Trade
If a country has a balance of trade deficit, then imports will exceed exports. As this happens, demand for foreign exchange will exceed supply and in turn, the local currency will depreciate in value. Likewise, a positive balance of trade will cause the local currency to increase in value.
A country’s balance of trade is often looked at in relation to those of its major trading partners with the intention of assessing the value of a currency in relation to its major trading partners.
Government Fiscal and Monetary Policies
Generally speaking, non-expansionary fiscal and monetary policies reduce expenditure which helps to bring stability to a currency and increase its value. Similarly, the higher rates of expenditure associated with expansionary fiscal and monetary policies and increased levels of inflation normally destabilise a currency, causing a fall in its value.
If government accrues more debt while borrowing to finance economic growth than is earned through growth, this can lead to increased levels of inflation. National governments may also end up printing money in order to pay their debts, which in turn can cause further inflation. Inflation, as we said earlier, deters foreign investment which causes a fall in the value of a currency.
Government Exchange Rate Intervention
In many cases, governments intervene in their currency’s exchange rate through their central bank. If a change to the exchange rate is likely to affect the economy and the trading opportunities of a country or if there is another long-term strategy in mind, central banks are able to affect the exchange rate.
The principal method through which this is achieved is through buying and selling the local currency. If the government would like the local currency to increase in value, they can buy up reserves of it (causing a shortage and therefore an increase in demand). Similarly, if they would like to decrease its value, they can sell reserves of it that have been kept. In addition to buying and selling the local currency, central banks and governments are able to adjust interest rates, print money, and use various other tools.
While the influence of speculation on the value of a currency tends to be highly unpredictable and short-lived, it can have an effect. Where speculators expect the value of a currency to fall, they will sell it causing the value of it to fall and where they expect the value of it to rise, they will buy it causing it to rise.
While the effects of this are felt in the foreign exchange markets, they are normally short-term.
As a general rule, increased economic strength and high levels of economic growth do not affect the value of a currency in the short term. However, in the long term, they are one of the key determinants of the value of a currency.
Going back to our earlier example of the euro maintaining its high value despite having low-interest rates, much of the reason behind this is that the countries which use the euro are seen as relatively economically strong compared to others.
In a similar way to economic strength, the political strength of a country also has a long term effect on the value of a currency. A country with a stable government will be less likely to experience economic shocks and to have stable financial policies and this tends to attract foreign investment.
Many of the developed nations of the world, such as the UK, have far more stable systems of government than the rest of the world. This is a good general predictor of stability in a country’s economy as a whole and its currency.
Free Floating Currencies
The fact that the major world currencies, such as the US dollar, the euro, and pound sterling are constantly shifting is actually a relatively new phenomenon.
The Gold Standard
Some people are unaware that before the early 1970s, most of the major world currencies were linked to the value of gold.
The value of currencies, including the US dollar, the UK pound, and those of countries that now use the euro, fluctuated with the value of gold. As the value of gold rose and fell, their value would rise and fall in line with each other. This meant that their value in relation to each other was always the same, giving stable exchange rates.
Fixed Exchange Rates
Similarly, some people are also unaware that nowadays many countries have their currency’s value tied to the value of other currencies. Most often, this is the value of the US dollar. For many countries, particularly developing countries, if their currencies were left entirely vulnerable to the effects of the things mentioned in this article, they would have highly unstable exchange rates.
In order to overcome this problem and to provide a stable exchange rate that facilitates international investment, governments of these countries often intervene heavily in the exchange rate in order to keep it at a certain level against another currency, such as the US dollar.
Most commonly this is achieved by holding reserves of the local currency and buying and selling it to manipulate the currency markets. If a currency falls too far in value, a government (through its central bank) can buy up the local currency causing an increase in its value through an increase in demand. If the currency increases too much in value, the government can sell reserves of the local currency, which will cause a lowering of demand and a fall in value.