Traditionally, the interest rate is set by the official monetary policy authority of a country, which has an important impact on the exchange rate. Therefore, it is also necessary for investors to learn about interest rates when learning foreign exchange knowledge.
Generally speaking, the difference between the short-term interest rates of two countries has an important impact on the exchange rate of the two currencies, although the long-term impact of absolute and real interest rates also has its role.
For currency market traders, the most important interest rates are those set by a country’s central bank. The main central banks are: Fed, European Central Bank, Bank of Japan, Bank of England, Reserve Bank of Australia, People’s Bank of China.
These central banks all agree that by adjusting the level of official interest rates, they affect the level of economic activity and the behavior of the country’s borrowers and lenders, whether they are residents or non-residents. At the same time, the adjustment of interest rates will also change the relative returns of investors in the country compared with other currencies, thus affecting the currency exchange rate accordingly.
If an economy is deemed to be expanding too rapidly, official monetary policy may be tightened and interest rates will likely be raised.
However, an increase in interest rates also has another effect, which is to increase the potential returns for investors and invested funds. Therefore, an increase in a country’s interest rate will help the country’s currency to a certain extent, because it attracts more investment funds.
In addition, if a certain economy is growing slowly, the central bank will stimulate the economy and the official currency may be loose. That is to say, the interest rate will be lowered.
Lower interest rates will reduce investors’ returns, so investors will sell the country’s currency in search of higher yields, and the country’s currency will weaken.
In advanced economies, interest rates are the fastest mechanism for influencing the behavior of lenders and investors. And in less developed economies, interest rates are not the only mechanism influencing spending patterns.
