Effect Of Interest Rates On Exchange Rates
Foreign currencies are traded with one another in a foreign exchange market. The price of one country’s currency depends on the exchange rate. Some currencies have higher exchange rates depending on the supply and demand. “For example, it may take $1.35 to buy 1 British Pound”; this means that it takes less British pound to buy a dollar. But, if the US increases the value of its dollar, the exchange rate would increase and it would cost more Pounds to buy a dollar. An increase in the exchange rate would affect the net exports. Higher exchange rates increase prices of the goods and services, the US products would be more expensive for the British consumer and these, in turn, would reduce the US Exports. The Exchange rates vary …show more content…
An interest rate is a percentage paid for the use of borrowed money. According to Rittenberg & Tregarthen (2012, p. 406), interest rates affect exchange rates directly because they are proportional to a nation’s supply and demand. Higher interest rates attract foreign investments because the return values of US assets are higher compared to other nations. The high-interest rates will lead to higher exchange rates and this depresses the exports of goods and services. An increase in the exchange rate appreciates the value of the dollar, making the imported goods cheaper and the US products more expensive.
For example, a bond that costs $800 with the Face Value of $1000 payable in a year, the interest rate will be 25%. A lower price of a bond relative to its face value will give a higher interest rate. This attracts foreign capital and the demand for US currency will be higher.
In this scenario, the low-interest rate gives a low return value for the investment. There will be less demand for the US assets, and it will also decrease the exchange rate.
What do you predict will happen to the foreign exchange rate if interest rates in the United States increase more than in the …show more content…
The increase of interest rate would appreciate the dollar value, making the US goods more expensive and less attractive for the UK, therefore the US net export would decrease. High-interest rates would attract more investment to the USA and that capital inflow would affect the exchange rate to appreciate; the increase of exchange rate reduces exports because the UK would need more British Pounds to buy USA goods and services. A strong dollar discourages exports and makes imports cheaper. For example, considering that 1.35 US dollar is worth 1 British Pound, a $10 calculator manufactured in the USA and exported to the UK would cost £7.41. But, now let’s suppose that $1 equals £1.20, the same $10 calculator would cost £12. When you consider this amount in terms of billions of dollars, the increase of interest rate would make the US products less competitive in relation to other countries. The UK would immediately find other trading partners with low-interest rates. Finally, the higher interest rate would also cause higher inflation which can “affect exports by having a direct impact on input costs such as materials and labor” (“Interesting facts about imports and exports,”