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Unit 2 Macro: Revision on Interest Rates and the Exchange Rate
3rd April 2012
The exchange rate measures the external value of sterling in terms of how much of another currency it can buy. E.g. in July 2011 £1 would buy you $1.65 and Euro 1.17. The daily value of the currency is determined in the foreign exchange markets (FOREX) where billions of $s of currencies are traded every hour. The value of the pound in the currency markets depends in how strong is demand for the currency relative to supply
Many factors affect the external value of one currency against another and one of these factors is the level of interest rates in a country compared to other economies. Money moves around the world economy seeking the best risk-adjusted rate of return. The rate of interest available on deposit in the banking system of a particular country is a factor that might drive what are known as “hot money” flows into and out of a particular currency.
Sterling against the Euro (daily exchange rate, euros per £1)
Data from Timetric.
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United Kingdom from Timetric
For example, if UK interest rates are higher than rates on offer in other countries then (ceteris paribus) we expect to see an inflow of currency into UK banks and other financial institutions.
The higher the positive interest rate differential, the greater is the incentive for funds to flow across international boundaries and into the economy with the higher interest rates.
Countries offering high interest rates can expect to see ‘hot money’ flowing across the currency markets and causing an appreciation of the exchange rate.
This can be shown by an outward shift in the market demand for a currency - shown in the diagram below
There are inevitable risks in shifting funds across international markets. What might happen to the currency if you leave $200,000 worth of cash in a UK bank account? What happens to the value of your investment if sterling depreciates against the US dollar? What are the risks in exchanging a similar value of US dollars and putting it into the UK stock market or into government bonds? Investors often consider the risk-adjusted relative rate of return from different financial investments.
Sterling against the US dollar (monthly average)
Data from Timetric.
To view this graph, please install Adobe Flash Player.
United Kingdom from Timetric
BBC News: Why do interest rates matter?
Geoff Riley
Geoff Riley FRSA has been teaching Economics for over thirty years. He has over twenty years experience as Head of Economics at leading schools. He writes extensively and is a contributor and presenter on CPD conferences in the UK and overseas.