A currency’s interest rate is probably the biggest factor in determining the perceived value of a currency.
In my previous article I covered why a Central Bank would raise or lower the interest rates. One of the biggest influence on a Central Bank’s interest rate decision is price ''stability'' or “inflation”.
It is generally accepted that moderate inflation comes with economic growth.
Currencies rely on interest rates because these dictate the flow of global capital into and out of a country.
Domestic interest rates directly affect how global market players feel about a currency’s value relative to another.
The 2nd fundamental factor is the interest rate diffrential. The interest rate spread between countries helps investors decide where to put their funds.
As interest rate level rise relative to interest rates elsewhere, the value of the domestic currency strengthens the foreign exchange rate changes.
Because of lower interest rates, international investors sell domestic securities, in order to move their money to higher yielding currencies. Therefore, demand for the domestic currency declines. The domestic currency drops in value.
With higher interest rates, demand for domestic security increases. Therefore the demand for domestic currency will increase because foreign investors are converting their currency. The domestic currency will rise in value.
NOTE
Although the market works logically in most cases, in reality there are exceptions: for example a currency will sometimes appreciate even if interest rates are falling relative to other countries. The interplay of these influences ultimately determines foreign exchange rate.
Stay tuned for my next article about the third fundamental factor and as always,
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