The Effect of Interest Rates on the Dollar

The Effect of Interest Rates on the Dollar
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Interest rates can motivate foreign investors to move investments from one country to another and therefore from one currency to another. Higher interest rates in the United States will, all things else remaining constant, prompt an increase in the value of the dollar. Conversely, lower interest rates will cause the dollar to lose value.

Interest rates to induce investment from foreign investors

By increasing interest rates, a nation can increase the desire of foreign investors to invest in that country. The logic is identical to that for any investment; the investor seeks the highest risk-adjusted returns possible. By increasing interest rates, the returns available to those who invest in that country increase. Consequently, there is an increased demand for that currency in order to be able to invest where the interest rates are higher.

Relationship of high interest rates and inflation

For many nations, especially developing nations, high interest rates coexist with high levels of inflation. Consequently, the nominal interest rate may be appealing but the real interest rate is actually much lower.

The high level of inflation dilutes the purchasing power of the currency.

Consideration of exports' effects on the dollar

Interest rates are far from the only factor that affects the value of a currency, including the US dollar. For example, the strength of exports and the level of imports can have a significant effect on the value of a currency. The US dollar would be stronger if the trade balance were not so heavily titled toward imports.

Recent trends in the dollar/interest rate relationship

In 2008 and 2009, the Federal Reserve has kept interest rates in the US very low. Because other nations have interest rates that are higher, investors are converting money away from the dollar and into other currencies in order to access these higher interest rates. Consequently, the value of the dollar relative to many other currencies has declined.

Weak dollar, low interest rates and increased costs

The low interest rates increase the risk of inflation, especially increases in the costs of imported goods. Low interest rates cause the value of the dollar to drop. Consequently, it requires more dollars to buy goods that are denominated in a different currency that does not have such low interest rates. The direct result of paying the foreign producer more is higher prices in US stores; the storekeeper must charge prices that at least recover his costs. Inflation can lessen the buying power of salaries earned in the US and therefore the quality of life enjoyed in the US.