Interest rates are pretty strongly related to exchange rates, along with other essential factors that can affect exchange rates at the economic level, such as inflation, its rate, and the political situation in the country. While higher interest rates may attract foreign capital by raising exchange rates, a comprehensive approach is needed to get a clear picture. Sen et al. suggest paying attention to emerging economies whose exchange rates are highly volatile in their growth (2020). Their comprehensive solution within the study framework involves searching for a mutual relationship between inflation, exchange rates, and interest rates. Empirically, as a rule, all these variables are interconnected, which is confirmed by numerous theories.
As a result, it was found that interest rates have a proven relationship with inflation, which is also affected by volatile exchange rates. A change in one of the variables entails changes in the other two, for the most part, dictated precisely by interest rates and inflation within countries (Şen et al., 2020). A particular case of the absence of correlations between interest rates and exchange rates is observed in Indonesia and South Africa, which may be dictated by the dependence of the exchange rate on other determinants and the long-term maintenance of the interest rate at the same level (Şen et al., 2020). However, the correlation was obvious in most of the considered cases of the experiment.
However, a decrease in interest rates, with its direct dependence on exchange rates, does not always lead to negative results. Since 2012, there has been a so-called policy of accepting negative political interest rates. Several countries use it to reduce exchange rate volatility, leading to weaker exchange rates (Thornton & Vasilakis, 2019). The decrease occurs due to central banks’ deliberate reduction of interest rates, which once again proves their connection. It is unusual in this situation that this non-obvious policy leads to positive results for the countries that have used it.
At the same time, other countries strengthen their exchange rate accordingly, which makes investments in these states more attractive. However, countries using NPIR policies may have many different factors, even non-economic ones, that contribute to the depreciation of the exchange rate when the overall economic situation is growing (Thornton & Vasilakis, 2019). This article does not mention countries, making it challenging to analyze the situation in more depth, as in the case of the first article.
It is worth mentioning the pandemic if we talk about the most current events that can affect countries’ policies, exchange rates, and much more. While this third article examines the impact of interest and exchange rates on equities, it also considers the country’s macroeconomic performance, demonstrating the connection between events (Nurmasari & Nur’aidawati, 2021). With its restrictions around the world, the pandemic has hit the economies of the world quite hard, especially in emerging economies. Large reserves were needed to keep the economy level, save jobs, and supply medical institutions with medicines, personal protective equipment, and much more.
Against this background, the country needed investments that could be attracted by strengthening the exchange rate by raising the central bank’s interest rates. Although the effect is still highly dependent on other external factors, the composite equity price index was affected by interest rates and the exchange rate by more than 94% (Nurmasari & Nur’aidawati, 2021). Although this tool was necessary under challenging conditions, it proved the complex dependence of interest and exchange rates.
References
Nurmasari, I., & Nur’aidawati, S. (2021). The Effects of Inflation, Interest Rates and Exchange Rates on Composite Stock Price Index During the Covid-19 Pandemic. Jurnal Mandiri: Ilmu Pengetahuan, Seni, Dan Teknologi, 5(2), 77-85. Web.
Şen, H., Kaya, A., Kaptan, S., & Cömert, M. (2020). Interest rates, inflation, and exchange rates in fragile EMEs: A fresh look at the long-run interrelationships. The Journal of International Trade & Economic Development, 29(3), 289-318. Web.
Thornton, J., & Vasilakis, C. (2019). Negative policy interest rates and exchange rate behavior: Further results. Finance Research Letters, 29, 61-67. Web.