Economics: Relationship between Policy Rates and Foreign Exchange Value

Does an increase in policy rates make the investment in domestic economy more attractive to foreign investors?

I really couldn’t grasp the idea of an increase in demand for the domestic currency if that’s the case. I think this has something with the rates in debt securities but is that the sole reason for the appreciation?


In the simplest form, increase in domestic interest rates will attract foreign investors as they will get higher returns on their investments.To invest in the domestic country, the foreign investors will need to exchange their currency for the currency of the domestic country, hence there will an increase in the demand of the domestic currency and hence the value of the domestic currency will increase. The investment can be in any assets, real or financial. Anyhow the above process will occur.

Gigaloo explained it in a very clear way.

High domestic interest rate will rather attract foreign savers to keep their money in local (domestic) banks than foreign investors, particularly in developing countries.

Like Flashback and Gigaloo rightly said, increase in policy rate will translate into increased foreign investment. See it this way also…

Increase in policy rate reduces domestic demand for money, which reduces domestic investment.

Reduction in domestic investment by domestic citizens leads to an increase in returns on investment to attract investors. However, since the policy rate is still high, only few domestic investors will be able to take advantage of the increased return on domestic investment, and thus this will attract foreign investment, which increases the demand for domestic currency.

There are a number of forces that affect exchange rates.

One is interest rate parity: the currency with the higher interest rate will _ depreciate _ against a currency with a lower interest rate.

Another is supply and demand: investors will tend to demand currencies with higher interest rates: the currency with the higher interest rate will _ appreciate _ against a currency with a lower interest rate.

As you can see: these forces work against each other. Sometimes one wins, sometimes the other wins.

That cleared things for me up a lot . I should have known that myself, kind of basic supply and demand. Can’t believe it’s as simple as that.

My other question was also answered in advance (relationship between futures/spot and interest rate).

Thanks guys!

My pleasure.

You are welcome.

These macroeconomic relationships are one of the most practically important part of economics and almost all of them can be explained with IS-LM model, including exchange rates. I am disappointed to see how little importance it has been given in the curriculum.