How interest rate affects currency

Question

I am quite new to economics. I was reading about changes in interest rates and its effect on currency value.

The fact is as interest rates increases, the currency value also increases and vice versa. However I want to understand the reason.

At first, I thought following: As interest rate increase, people borrow less, spend less, so cost of goods decreases, value of currency increases.

However when I read in investopedia, it says following:

Generally, higher interest rates increase the value of a given country's currency. The higher interest rates that can be earned 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.

Q1. Now I dont understand what does it mean by increasing the demand for and value of the home country's currency. What is it meant by demand for currency by foreign investors?

In another article it says:

The rise of interest rates in a country often spurs inflation, and higher inflation tends to decrease the value of a currency.

But on the same page, it says:

Generally, higher interest rates increase the value of a given country's currency.

Q2. Why these two different statements are there?

If I understand it correct, the word "spurs" here means increases inflation. But this confuses me.

My understanding is:

• interest rate increases, people can borrow less, spend less, economy slows, inflation decreases, currency value increases
• interest rate decreases, people borrow more, spend more, economy grow, inflation increases, currency value decreases

Q3. Are these understanding correct in general (though I understand the relation is not that straight forward and there are other factors too that affects currency value / inflation)?

Answer 1

Its important to keep in mind that the exchange rate is a "price for currency" and just like any other price it is determined by supply and demand. The main question now is what determines supply and demand for currency?

There are two main models that tell us how exchange rates behave based on the two main forces driving demand (and supply) for currency.

One factor is trade of goods (the goods market). If foreigners buy our goods they need our currency, so they demand our currency and higher demand ceteris paribus (all else staying constant) leads to a higher price and the value of the domestic currency increases. Based on such considerations in the goods markets we have the model of Purchasing Power Parity (PPP). However empirically it does not always hold and in reality it is mostly expected to hold in the long run.

Answer to Q1: Beyond the goods market discussed above, the second main factor is the capital market and that is what Investopedia is referring to. This gives rise to the model of Uncovered Interest Rate Parity, called UIP (there is also a "Covered Interest Rate Parity Model"). This says that if interest rates are higher in the domestic country compared to the foreign country, then foreign investors would like to invest in our country to get the higher returns. To do so they need our currency. So they buy it (demand it) and therefore as long as supply of currency doesn't increase (the central bank printing more money) the price and value of a currency must increase. Also note that there's no reason to expect the central bank to change the supply in a floating exchange rate regime, which most countries have (i.e. there is no attempt to intervene in the exchange rate to keep it fixed).

Answer to Q2: It is not necessarily true that a higher interest rate should increase inflation in general. However increasing the interest rate can decrease inflation. Your understanding of inflation is correct. The second part of the second quote you gave, that higher inflation decreases the value of the currency, however is correct. This is due to the first model we discussed, the PPP. The idea is that inflation makes goods more expensive and therefore our goods have less foreign demand, which leads foreigners to have less demand for our currency (they buy less of our goods so they need less of our money to buy our goods) and less demand for the currency reduces the value of the currency.

Answer to Q3: I believe this follows from the general discussion above.

Answer 2

Earlier posters, you're in general correct..But note that inflation can have different drivers - demand or cost..

If the inflation is demand-pull, then your submission that higher interest rate lowers inflation would be fine..However, if the inflation is cost push, and we have seen this on some occasions, more recently in Nigeria, then higher interest rate can, in fact, increase inflation through an increase in production cost..Won't speak much about this. More info can be gotten via Google.

Original poster, it depends on the kind of inflation that the article refers to.

As for exchange rate.....

The monetary model of exchange rate does predict that higher interest rate increases prices, inflation and depreciates exchange rate in the long run. This is not mainstream thinking, I agree, but it's a result which has found merit when empirically verified in a number of countries. The wisdom that higher interest rate reduces prices and strengthens exchange rate is a short term concept and known as the traditional approach to exchange rate determination which is based on the traditional keynesian/income model...:)

All these are theories upon theories and none is really right or wrong. They all make sense when viewed through the lenses of their respective assumptions.

Itankansogorobodo

Answer 3

The use of the word “spurs” is incorrect.

Higher interest rates -> people borrow less -> people spend less -> aggregate demand shifts left (falls) -> prices fall (prices falling means inflation is reduced; definitely not increased (or spurred)

As for the relationship between a country’s exchange rate and its interest rate; it’s actually very simple. Basically there’s a whole lot of money managed by all the big global banks and as soon as they think they can get a better % return on those large chunks of cash, they’ll shift their money into those assets

So say JP Morgan think the Reserve Bank of Australia is going to increase Australia’s interest rates. JP Morgan will buy Australian dollars in order to put their funds into an Australian bank account (or other Australian dollar denominated assets) in order to take advantage of the better interest rates

A lot of other global investment firms would probably do similar.. this extra demand for Australian dollars will put upward pressure on it and it will appreciate against other currencies

Long story short, as soon as money markets believe a country’s interest rates might go up, they’ll buy that currency (and vice versa). The more certain they are, the more the currency will appreciate as they buy it and park their money there

NB: the handy way of remembering this relationship is to simply think about what you’d do with your own money if you knew two countries offered different interest rates - all else equal, you’d probably want to put your money into the one with the higher returns, meaning you have to trade whatever currency you currently hold for the new currency, causing it to appreciate in value.

Answer 4

Maybe this is too late to Answer.

But to get the answer of your query you need to consider two aspects-

First, you need to consider inflation as an indicator in the economic barometer and it is directly reflects the growth of economy, but too much inflation can cause stagflation and too low inflation can cause deflation. So too much incline of this indicator in any direction tends to crash of the economy.

Second, currency is get traded in the world market. And for currency demand and supply are considered in terms of currency trade happens between two countries. For carry-trade country holds currency of other countries having the higher interest rate. Let's consider Country A having interest rate 1.2 holds currency of another country B having an interest rate of 1.5 for 3 months. Then country A gets paid by the country B based on its interest rate. This is called investment in currency. Since the higher interest rate increases demand of the country B currency it increases the value of its currency.

Now the value of the currency in the world market is bad or good depending upon what are policies country willing to imposed on import and export. Since if the country is targetting more export then the lower currency value is considered as good for the economy and if the country is targetting more import then higher currency value is considered as good for the economy, read more on balance of trade.

Answer 5

This came in late but let me simplify things a little bit, An increased Real G.D.P of an economy will lead to Increase in Demand, Which will lead to Increase in Prices(inflation), this will then lead to Increased Real Interest Rates(The banks will try an make up for the increase in prices of goods), This of course now leads to Decreased Demand > Disinflation > Decreased Interest Rates > Decreased Real G.D.P.

Answer 6

Well, maybe it's poor phrasing by Investopedia. Inflation would drive interest rates up, but not the other way around.

All things being equal, increasing interest rates will reduce inflation or generate deflation.

In the real world, all things are not equal and when interest rates start going up, it's often trying to keep up with inflation, so they end up linked together.

As for the currency appreciation, higher interest rates won't drive all form of investment up, only lending from global markets will increase. On the other hand, businesses will be incentivized to relocate outside the country and also consumers will be importing a lot more.

Answer 7

While individual actions can be an important variable in determining exchange rates, the role of private banks far outweighs what the public can and does do.

While there are non-monetary factors in determining exchange rate, monetary components are still of primary importance.

Put simply, banks create money. They create money (aka liquidity) by mismatching short term debt with long term assets (maturity mismatching). When banks face higher interest rates, they can not create as much money (we are talking broad money like M3). So less money from nation X relative to nation Y, means the money from nation X will go up.

If you are curious about this works, I suggest reading the following graphs.

Here is a value of the US dollar over time (weighted against multiple currencies):

http://www.shadowstats.com/alternate_data/dollar-index-charts

Here is a graph of the M3 money supply:

http://www.shadowstats.com/charts/monetary-base-money-supply (4th chart down...the long term one).

Notice how they share the peaks in 1985, a trough from 1990 to 1995, a peak in 2003 and then a downswing in 2005. That to me is a pretty good correlation and proof that more money (M3) = weaker dollar.