Interest, Inflation and Exchange Rates

High levels of inflation within a country are typically associated with the weakening of the value of that country’s currency against that of its trading partners. This is because any money invested in the currency is likely to lose value as interest levels cause the currency to depreciate. This lack of investment interest can cause exchange rates to drop. However, high levels of interest are often accompanied by high interest rates as well, which have the opposite effect – typically causing exchange rates to rise!

Higher interest rates attract investment for obvious reasons, since investors can expect higher returns that they could when investing in alternative currencies. However, this is rarely enough to counteract the damaging effect of high levels of inflation, which almost always have a negative impact on exchange rates. The result is that careful balance is required between rates of interest and inflation, in order to stabilise the exchange rate of a currency.

Of course, one should always bear in mind that the exchange rate can have as much of an impact on inflation and interest as they have on the exchange rate. The relationship between the two works both ways and should never be over-simplifed.