How do interest rates affect exchange rates?

When you send money abroad, you’re going to encounter exchange rates. Exchange rates dictate the value of one currency against another and are constantly changing. There are many factors that drive the fluctuation of exchange rates, including interest rates.

But how do changes in interest rates affect exchange rates? Find out the connection between interest rates and exchange rates in our guide.

What are interest rates?

Interest rates are the cost of borrowing money or the reward for saving it, expressed as a percentage. This percentage is set by banks or lenders and can differ based on various conditions.

For example, if you take out a loan, you’ll need to pay interest on top of the loan amount. If you take out a loan of £1,000 at a 5% interest rate, you’ll owe an additional £50, making your total repayment £1,050.

When you deposit money into a savings account, the bank pays you interest for keeping your money with them. This interest adds to your savings over time, rewarding you for letting the bank use your money.

What factors impact interest rates?

There are various factors that influence how interest rates fluctuate over time. These fluctuations then impact exchange rates.

Here are some of the main factors that drive changes in interest rates:

Supply and demand

The demand for money or credit plays a crucial role in setting interest rates. When demand is high, meaning more people or businesses need to borrow, interest rates tend to increase because lenders can charge more. When demand is low, interest rates typically decrease, making it cheaper to borrow.

There are various factors that can influence the demand for credit in a country. Economic growth, consumer confidence, and business investment can drive up demand. If a country is experiencing economic downturns or periods of political uncertainty, demand tends to decline.

On the supply side, the amount of money available for lending directly affects interest rates. When there’s plenty of money to lend, interest rates tend to drop as lenders compete for borrowers. When money is limited, interest rates rise because lending becomes more costly.

Like demand, there are various factors that influence the money supply in an economy. This can be driven by central banks who can adjust the money supply through their policies. The level of savings and the availability of credit from banks also determine interest rates.

Inflation

Inflation is the rate at which the prices of goods and services increase over time. When inflation is high, interest rates tend to rise because central banks increase rates to slow down spending and bring inflation under control. By raising interest rates, borrowing becomes more expensive, which helps reduce the demand in the economy.

Government policy

Government policies and actions can also influence interest rates. For example, when a government needs to borrow money to fund its expenditures, it may issue bonds. The interest rates on these bonds can affect interest rates in the economy.

Global trade

Global trade activities, including exports and imports, influence a country’s currency value. When a country exports more than it imports, there is an increased demand for its currency. This stronger currency can affect economic conditions, causing central banks to potentially decrease interest rates to maintain stability.

When a country imports more than it exports, it may experience a trade deficit, which can weaken its currency. To counter this, central banks might raise interest rates to attract foreign investment and help stabilise the currency.

How do changes in interest rates affect exchange rates?

Changes in interest rates have a direct impact on exchange rates. When interest rates rise, the currency of that country typically strengthens, leading to a higher exchange rate. This means you may get more foreign currency for the same amount of money when sending it abroad.

For example, if interest rates in the UK increase, the British pound (GBP) could become stronger against the US dollar (USD). You would receive more USD for each pound when transferring money to the United States.

When interest rates decrease, the currency tends to weaken, resulting in a lower exchange rate. If interest rates in the UK were to drop, the GBP might lose value against the USD. This would mean getting fewer dollars for each pound sent, making your transfer less cost-effective.

If you’re using a money transfer app, you can easily check the current exchange rate before sending money abroad. This allows you to make informed decisions and get the most value out of your transfer.

Other factors that impact exchange rates

While interest rates influence exchange rates, there are other factors that play a role in the exchange rate. Let’s look at what drives exchange rates:

Stock markets

The performance of stock markets can impact exchange rates. When a country’s stock market is strong, it often attracts foreign investment, increasing demand for that country’s currency and strengthening its value. A declining stock market can lead to a weaker currency as investors pull out, reducing demand and lowering the exchange rate.

Economic performance

A country’s economic performance, often driven by political stability, affects the strength of its currency. Strong economic performance can attract foreign investment, leading to a stronger currency and improved exchange rate.

Government debt

Government debt levels can also impact exchange rates. High levels of debt may lead to inflation and reduce investor confidence in the country’s currency, weakening the exchange rate.

FAQs

How do high interest rates affect exchange rates?

High interest rates usually lead to a stronger exchange rate because they attract foreign capital seeking better returns. This increased demand for the currency boosts its value on the global market.

How do interest rates affect foreign exchange?

Interest rates influence foreign exchange by affecting currency demand. Higher interest rates attract foreign investors, increasing currency demand and value. This increase in demand and value will increase exchange rates.