The interaction of various variables determines the exchange rate between two currencies. Some variables have a greater impact on currency rate setting than others. The interest rate is one such variable.
Changes in interest rates, in general, cause substantial variations in the value of all currencies. In reality, every major currency crisis has preceded a significant adjustment in interest rates. Furthermore, some currencies, such as the EURO dollar pair, are always sensitive to changes in interest rates. This article will look at why interest rate changes have such a big impact on the forex market.
Investors follow the highest return.
Capital inflows and outflows into and out of any country have a significant impact on the exchange rate of a certain currency. Since the advent of globalization, if a country’s economic foundations are sound enough, foreign capital has flowed freely into that country, even if its regulations are slightly restrictive.
The growing money inflows into China and India are examples of this. Furthermore, investors prefer to reinvest the capital’s returns in the same country. Avoiding currency outflows and enhancing the currency’s value as a result.
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Businesses want to pay the lowest cost.
The disadvantage of having high-interest rates is that firms find it difficult to borrow at those rates while still operating profitably. The rate set by the central bank becomes the economy’s base rate. As a result, all organizations and people must pay a rate that is greater than the base rate.
Businesses will continue to borrow if the rate of return generated by the business is high enough to meet rising interest expenses while still generating profit. If this is not the case, investor cash stored in banks will have no takers, forcing interest rates to decline. This will result in capital outflows as investors seek better places to put their assets.
Direct correlation between Interest and Forex rates.
It is very clear from the preceding statements that there is a direct relationship between the interest rates common in a given economy and the currency value of that economy. As a result, if the Chinese government boosts interest rates, the value of the Yuan is expected to rise. This is because investors from all over the world will rush to park their funds in Chinese banks, causing a surge in Yuan demand.
Real and Nominal Rates
We addressed nominal interest rates in the preceding topics. However, it is the act of the actual interest rate, not the nominal rates, that affects a market and generates currency rate swings. Assume a country’s interest rate has been raised to 10%. However, the country is experiencing 9% inflation. The real interest rate would then be 1%, and the country’s currency would not appreciate despite its high-interest rate.
Real interest rates are not reported. Therefore, exact figures are not available.
Another thing to consider is that when markets determine price, they also consider future possibilities. As a result, currency rates in the forex market reflect the interest rate environment in the country at any particular time and the probability of future interest rate adjustments.