The Relationship between Interest Rates and Exchange Rates

So the interest rates had been raised by a quarter of a point last month to better manage the US economy. We know what rate hikes can do to us. Read more on “5 Reasons Why An Interest Rate Hike Can Affect You.” Capital is likely to shift back to the US economy because it makes more sense to deposit your money with the U.S. And when the demand of the US currency increase, what happens next?

Yes, its currency would appreciate.

 

Interest rates and exchanges rates are two economic variables which influence a large number of other economic variables such as national income, unemployment, inflation and the balance of payments. The United States is one of the many countries where its central bank uses interest rates to control the economy. However, not all would follow suit. Singapore is one such economy which uses exchange rates to manage the economy. The difference in choice of policy instrument is largely attributed to the differences in sizes and the compositions of the economy.

That being said, while interest rates is one of the major factor that can influence a currency’s value and its exchange rate, the final determination of the currency’s rates ultimately lies from other elements that can impact the overall financial health of a country with respect to other nations as well.

This is because there is another relationship that exist between interest rates and inflation. An increase in interest rates (again) would not only increase mortgage costs, it makes buying a home even more expensive. Costs of borrowing is going to be even more expensive. Consumers would have lesser to spend because more of their disposable income needs to be allocated to repay their debts. When the economy begins to shrink from lesser consumer spending and investments, we may eventually fall into a deflationary environment. Read more on “5 reasons why Deflation spells bad news for any economy.” Capital is likely to flow out because any rational investor would know how deflation can spiral into a vicious cycle of higher unemployment and greater debt problem. Demand for the domestic currency would thus fall, causing a devaluation of the country’s currency.

 

Of course, these are under extreme conditions where rate hikes can and should only be done gradually for it to be effective. Just as in the case of the U.S., higher rates would certainly prompt investors to move their money into US dollar-dominated assets and in turn causing the US dollar to appreciate even further. People may not get used to it, because rates have been ultimately low for almost a decade, but they will. Persistently low rates have not been healthy for the economy either and if Trump could keep to his promise of making America great again, it could definitely add to growth in 2017 and 2018. A stronger economy would no doubt point to another potential rate hike which would then bring about the same cycle all over again.

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