How do changes in national interest rates affect a currency's value and exchange rate?

All other factors being equal, higher interest rates in a country increase the value of that country's currency relative to nations offering lower interest rates. However, such simple straight-line calculations rarely, if ever, exist in foreign exchange. Although interest rates can be a major factor influencing currency value and exchange rates, the final determination of a currency's exchange rate with other currencies is the result of a number of interrelated elements that reflect and impact the overall financial condition of a country in respect to that of other nations.

Generally, higher interest rates increase the value of a given country's currency. The higher interest rates that can be earned tend to attract foreign investment, increasing the demand for and value of the home country's currency. Conversely, lower interest rates tend to be unattractive for foreign investment and decrease the currency's relative value.

However, this simple equation is complicated by a host of other factors that impact currency value and exchange rates. One of the primary complicating factors is the interrelationship that exists between higher interest rates and inflation. The rise of interest rates in a country often spurs inflation, and higher inflation tends to decrease the value of a currency. If a country can manage to achieve a successful balance of increased interest rates without an accompanying increase in inflation, then the value and exchange rate for its currency is more likely to rise.

Interest rates alone do not determine the value of a currency. Two other factors that are often of greater importance are political and economic stability and the demand for a country's goods and services. Factors such as a country's balance of trade between imports and exports can be a much more crucial determining factor for currency value. Greater demand for a country's products means greater demand for the country's currency as well. Favorable gross domestic product (GDP) and balance of trade numbers are key figures that analysts and investors consider in assessing the desirability of owning a given currency.

Another important factor is a country's level of debt. While they can be managed for some period of time, high levels of debt eventually lead to higher inflation rates and may ultimately trigger an official devaluation of a country's currency.

The recent history of the United States clearly illustrates the critical importance of a country's overall perceived political and economic stability. In recent years, U.S. government and consumer debt has exploded to new high levels. In an attempt to stimulate the U.S. economy, the Federal Reserve has maintained interest rates near zero. Despite these facts, the U.S. dollar has enjoyed favorable exchange rates in relation to the currencies of most other nations. This is partially due to the fact that the U.S. retains, at least to some extent, the position of being the reserve currency for much of the world. Also, the U.S. dollar is still perceived as a safe haven in an economically uncertain world. This fact, more so than interest rates, inflation or other considerations, has proven to be the overriding and determining factor for the relative value of the U.S. dollar.

Source: Investopedia