Causes of foreign exchange rate fluctuations: changes in the interest rate

International Trade and Globalisation – Foreign Exchange Rates

Objective

Understand how changes in interest rates cause fluctuations in foreign exchange rates.

Key Concepts

• Foreign exchange rate – price of one currency expressed in terms of another.
• Interest rate – the cost of borrowing money, set by a country’s central bank.
• Capital flows – movement of money for investment, influenced by relative returns.

How Interest Rates Influence Exchange Rates

When a country’s interest rate rises relative to other countries, its financial assets become more attractive to investors seeking higher returns. This increased demand for the domestic currency leads to an appreciation. Conversely, a fall in interest rates makes domestic assets less attractive, reducing demand for the currency and causing depreciation.

Mechanism Explained

1. Interest rate change announced – Central bank raises or lowers the policy rate.
2. Investor response – Portfolio investors compare expected returns (including interest) across countries.
3. Capital movement – Funds flow into the higher‑rate country (or out of the lower‑rate country).
4. Currency demand shift – More demand for the higher‑rate currency → appreciation; less demand → depreciation.

Illustrative Example

Assume the UK raises its base rate from 2% to 4% while the US Federal Reserve keeps its rate at 2%.

Expected return on a UK‑denominated bond:

\$\$

R{UK}=i{UK}+E\left(\frac{\Delta e}{e}\right)

\$\$

where \$i{UK}=4\%\$ and \$E\left(\frac{\Delta e}{e}\right)\$ is the expected change in the exchange rate. If investors expect the pound to appreciate, the total expected return exceeds that on a US bond (\$i{US}=2\%\$), prompting capital inflow to the UK and appreciation of the pound.

Factors That Modify the Interest‑Rate Effect

• Inflation differentials – High inflation can offset the benefit of higher interest rates.
• Risk perception – Political or economic instability may deter investors despite higher rates.
• Liquidity of markets – Larger, more liquid markets attract more capital flows.

Table: Impact of Interest Rate Changes on Exchange Rate

Key Points for Revision

• Higher interest rates → higher expected returns → increased demand for the currency → appreciation.
• Lower interest rates → lower expected returns → decreased demand for the currency → depreciation.
• Exchange‑rate movements can be temporary if other factors (inflation, risk) change.
• Central banks may adjust rates to influence the exchange rate as part of monetary policy.

Practice Question

Country A raises its interest rate from 3% to 5% while Country B keeps its rate at 3%. Explain, using the concepts above, how this is likely to affect the exchange rate between Country A’s currency and Country B’s currency over the short term.