There is a link between interest rates and the exchange rate of the currency.
If domestic interest rates increase above those in other countries, then the domestic currency’s exchange rate is likely to appreciate 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 foreign banks of their respective countries. If interest rates increase in the domestic country, those investors will close their deposits and convert their own foreign currency into the domestic country’s currency. It is because higher interest rates in the domestic country will allow them to gain more interest when saving money in the domestic bank. Their funds will most likely be invested in the domestic country’sbank where the saving rate is higher than those in other countries.
So, if domestic interest rates rise, then short-term investors will cause stronger demand for the domestic currency. It will cause an appreciation in its exchange rate.
