How does increase in interest rates lead to an increase in exchange rates?
January 31st, 2010 by Lenny
Can someone explain it to me plainly? ALSO, I’m wondering if it works vice versa - does lowering interest rates lower the exchange rate?
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Hello,
Yes you are correct in what you are saying. I will use and example as it’s easier to follow the reasoning. An increase in the interest rates is always good news for savers - if the IR is 2% and you put £10 into the bank you will earn 20p if the IR is 3% you earn 30p. Now think about this with larger amounts of money, you could earn alot more by putting your money into a bank where the IR is higher. Let’s say you have US$ and the UK Bank of England increases its IR from 2% to 3%. When you move your money, you are increasing the supply of US$ in the market (ECO 101: increase in supply lowers the price), you are also wanting UK£ (increase in demand for £ increases the price) - put these two factors together and you will find that the £ gains strength. When a currency becomes stronger it means it is worth more of the other currency it is compared against. £1 = $ 1.5 –> £1 = $1.6
The increase in the IR will lead to the £ strengthening against the $ leading to it being worth more $. The opposite is also true.
Hope this helps.