There is a link between interest rates and the exchange rate of the currency.
If domestic interest rates decrease below those in other countries, then the domestic currency’s exchange rate is likely to depreciate against other currencies.
Why is this?
One source of demand for a currency on FOREX, the foreign exchange market, is from international short-term investors.
They tend to invest their capital into deposits in the domestic bank. If interest rates decrease in the domestic country, those investors will close their deposits and convert the domestic currency into the foreign currencies of their respective countries. It is because lower interest rates in the domestic country will not allow them to gain more interest when saving money in the domestic bank. Their funds will most likely be invested in the foreign country’s banks where the saving rate is higher than those in the domestic country.
So, if domestic interest rates decline, then short-term investors will sell out the domestic currency causing higher supply for the domestic currency. It will cause a depreciation in its exchange rate.
