What is the relationship between interest rates and currencies?
Jun 14, 2021
iCrowdMarketing powered by iCrowdNewswire
Being an essential transmission channel for monetary policy, the exchange rate reaction to an interest rate change is undoubtedly the most significant price in any market since it influences all other prices.Many variables impact the exchange rate, particularly short-term interest rates, which are the subject of this study. Nonetheless, it is already commonly acknowledged that current theories do not give a reasonable explanation for this link.
According to current economic theory, boosting interest rates decreases aggregate demand economic growth, resulting in reduced inflation. This statement is based on demand-pull dynamics, which imply that higher interest rates affect the purchasing power of people by increasing the cost of borrowing, making keeping a more appealing choice.
Savings increases the supply of money in circulation, which decreases hyperinflation and raises the value of the currency. Currency appreciation harms the export market while easing prospective wage constraints since labor demand falls as a result of lower competitiveness for locally traded products and services.
An alternative school of thinking is based on cost-push effects, which predict that rising interest rates will lead to increased prices. However, notwithstanding the greater funding costs associated with higher interest rates, one leading argument is that monetary policy has genuine demand-pull effects because companies suffer a cost when adjusting pricing.
A menu cost is a cost to a corporation when its prices vary in economics. It is stated that if cost parameters such as finance costs fluctuate insignificantly, a corporation may opt to exist with only minor disequilibrium rather than suffer the menu cost. The cost-push effects have been largely ignored in the preceding reasoning.
Interest rates and Exchange rate - Example of the U.S.
When the Fed increases interest rates, investors seeking gains prefer to sell foreign currency assets and acquire dollar-denominated investments. The greater the disparity between US interest rates and those of other nations, the more probable it is that traders will shift from foreign-denominated to dollar-denominated securities. Investors demand dollars in order to acquire dollar-denominated assets.
As a result, people swap alternative currencies for dollars, and the dollar exchange rate rises as a result of their increasing liquidity in the market in terms of demanding the USD. Whenever the Fed lowers interest rates, traders sell dollar-denominated investments and acquire foreign assets, causing the dollar's currency values to fall.
As the exchange rates and currency values are an important part of Forex trading and significantly affect the country’s economic growth, the U.S. starts to reduce the restrictions on Forex trading. Since the mitigated regulations, many FX brokers started to encourage new investors to start trading with them and allow them to implement Forex trading without deposit, which is kind of a bonus and allows newcomers to trade without depositing money. As the USD is quite demanded in the marketplace which grows the value of the national currency, both Forex brokers and the USA can be in a win-win situation. Firstly, brokers can attract more investors with their no deposit bonuses, and secondly, the USA can make its currency more liquid and valuable.
The Fed's interest rate choices have a reverse effect on the interest rate choices of other financial institutions. When the Fed raises interest rates, the dollar strengthens, and the currency exchange rates of other countries fall. This boosts the cost of imports into such countries, contributing to inflation.
If imports are primarily priced in US dollars, as is common in developing nations, a decreasing currency exchange rate can make it harder for enterprises and authorities to fulfill dollar-denominated loans.
To counteract the effect of the Fed's activities, central banks, particularly in developing nations, may seek to strengthen their currency exchange rates by hiking interest rates in tandem with the Fed.
When the Fed lowers interest rates, other nations' currency exchange rates tend to rise, hindering their export markets. Instead of accepting reduced exports, central banks in such nations may choose to decrease interest rates in accordance with the Fed.
Thus, the Fed's interest rate actions will affect the value of the dollar, and the value of the currency can impact interest rate choices in other nations.
Inflation and real interest rates affect
Higher inflation tends to depreciate the value of a currency. When products become less competitive as a result of high inflation, demand diminishes in comparison to other nations with smaller inflation rates.
Let's say you have two nations:
In India, the inflation rate is defined as 8% and interest rates are 8% as well. - The real interest rate, in this case, is 0%.
Singapore's inflation rate is 4%, while interest rates are 5%. - The real interest rate is one percent.
It is preferable to invest in Singapore, which boasts a favorable real interest rate of 1%.
Why not invest in India, where the interest rate is 8%? If you invest your money in India, you will obtain a fantastic interest rate of 8%; but, with 8% inflation, you may anticipate the rupee to depreciate by 8% a year.
In Singapore, the nominal interest rate would be lower, but the Singapore money would only decline by 4%.
Note that 4% inflation does not imply that a currency would decline by 4%. However, when other variables are taken into account, increasing inflation tends to degrade the value of products because they become less appealing. This is a simplification to aid comprehension.