Interest-Rate and Exchange-Rate Channel

Interest-rate changes can influence a currency’s value by changing how attractive domestic financial assets are to international investors. The interest-rate-exchange-rate channel operates through differences in expected returns across countries, which affect capital flows and demand for currencies.

From interest rates to currency demand

Investors compare returns on domestic and foreign assets. When domestic interest rates rise relative to foreign rates, domestic interest-bearing assets may become more attractive, provided exchange-rate expectations and risk remain broadly unchanged.

• A higher interest-rate differential can attract foreign portfolio investment or encourage residents to retain funds domestically, increasing net demand for the domestic currency.
• Investors buying domestic assets generally need domestic currency, so additional demand can cause appreciation under a floating exchange rate.
• Conversely, relatively lower domestic rates can encourage investment abroad or capital outflows, putting depreciation pressure on the currency.
• The relevant comparison is with foreign interest rates: a domestic rate increase need not improve relative returns if foreign rates rise more.

Expected returns matter more than interest rates alone

International investors consider the expected exchange-rate movement as well as interest income. A higher domestic yield may be offset by an expected fall in the domestic currency’s value.

• For an unhedged foreign investor, domestic-currency depreciation reduces the return when the investment is converted back into the investor’s currency.
• In the simplified uncovered interest parity framework, the interest-rate advantage is offset by expected currency depreciation, equalising expected returns.
• Country risk, liquidity, capital controls and transaction costs can prevent this simplified relationship from holding exactly.
• Exchange rates can respond when a policy change is anticipated, rather than only when the interest-rate decision occurs.

Which capital flows respond most?

Portfolio investment, especially in debt securities, can respond relatively quickly to changes in yields. Foreign direct investment is generally less immediately sensitive because investors also consider long-term profitability, market access and production conditions.

• Higher yields do not guarantee inflows if investors expect substantial depreciation or perceive greater financial risk.
• Exchange-rate hedging costs can offset an apparent interest-rate advantage, so the headline yield alone does not determine attractiveness.

Exchange-rate regime and policy implications

Under a floating exchange rate, changing capital flows can alter the currency’s market value. Under a fixed or managed regime, central-bank intervention can absorb some of the pressure through changes in foreign-exchange reserves.

• Higher interest rates may support the currency but also raise domestic borrowing costs and restrain demand.
• The impossible trinity means that a country cannot simultaneously maintain a fixed exchange rate, free capital movement and fully independent monetary policy.