The impact of the interest rate on the exchange rate

In today’s global financial world, everything is interconnected. Smaller economies depend on larger ones, and capital continues to flow to profitable regions. At the same time, the current financial model uses the same tools to regulate economic growth or overcome crises that were used hundreds of years ago. One of such powerful national and global instruments is the interest rates of the Central Bank.

Interest rates are the most important and main instrument of influence of any Central Bank, both on the economy and on the exchange rate of the national currency. At the same time, the main task of the Central Bank is to support the national currency at a certain level. Why is it so important?

First of all, inflation depends on the exchange rate, that is, the depreciation of the currency in relation to goods over a certain period of time.

Most of the Central Banks of the world, before deciding to raise or lower the interest rate, pay attention to inflation, the second significant parameter is the unemployment rate. The parameters of inflation and the unemployment rate are very important for the economy. They directly affect citizens and generate or reduce social tension. For example, a high level of inflation (hyperinflation) leads to a depreciation of the savings of citizens and at the same time an increase in the cost of goods and services, causing a double blow. High unemployment is a characteristic indicator of a crisis in the economy. With high unemployment, it is not only difficult to get a job, but it is also impossible to count on good wages, and the number of crimes also increases.

Changes in rates have a direct impact on the entire economy (even if it does not happen all at once). Each country has several types of interest rates. The main interest rate is the discount rate (refinancing). In fact, this is the discount rate at which the Central Bank issues loans to commercial banks.

Why discount? There are two main methods for calculating interest at a rate. Interest rate – in this case, the interest on the loan is paid as the loan is repaid. Discount rate – in this case, the amount of the loan is reduced by the interest on the loan.

In addition to the discount rate, there are also deposit and interbank rates, but it is the accounting rate that has the greatest impact on the exchange rate. Let’s figure out how the interest rate affects the exchange rate?

How does a rate hike affect the exchange rate?

Two events can lead to an increase in the rate:

• The first event is a sharp drop in the value of the national currency against the background of the economic crisis. For example, in 2015, a currency crisis began in Russia against the backdrop of falling oil prices, the conflict with Ukraine, and the introduction of the first Western sanctions.
• The second event is a possible “overheating” of the economy and rising inflation. In this case, the Central Bank is looking closely at the inflation target and the unemployment rate.

The influence of the interest rate on the exchange rate is as follows, the higher the rate, the more attractive the currency (especially for non-residents). An increase in the rate leads to the strengthening of the national currency in the medium and long term. At the same time, the increase in the rate negatively affects business lending, leads to an increase in unemployment and the withdrawal of funds from circulation, having a negative impact on the entire economy.

How does the rate cut affect the exchange rate?

After reading the impact of raising the interest rate, it would be logical to assume that lowering it has the opposite effect. Low rates make the national currency less popular among non-residents. Yields on debt instruments in this case are low, the demand for the national currency is weak, and the exchange rate is falling. However, low rates mean better loans for households and companies, resulting in increased production and jobs, and reduced unemployment.

Conclusion

The influence of the interest rate on the exchange rate is direct, interest rates rise – the currency strengthens, and if they decrease, it weakens. At the same time, lowering rates stimulates the growth and development of the economy, while raising it reduces economic growth.