Question

Explain the relationship between interest rates and exchange rate

Answer 1

If a domestic economy offers higher interest rates, it will attract foreign investors because it will offer foreign lenders higher return on investment. This will cause foreign investors to demand more of domestic currency, increasing the value of domestic currency. Therefore, domestic currency appreciates.

If the domestic country offers lower interest rate, foreign investors will demand less of domestic currency. It will decrease the value of domestic currency, that means the currency depreciates.

Therefore, there is a positive relationship between interest rate and exchange rate. When interest rate increases, exchange rate increases and when interest rate decreases, exchange rate decreases.