What is the relationship between foreign exchange rates and interest rates?

First, the interest rate policies of various countries will affect the current account and thus have an impact on the foreign exchange rate. When interest rates rise, their credit will be further tightened and loans will decrease, so related investment and consumption will naturally decrease accordingly. Reduced consumption will lead to oversupply in the market, followed by falling prices, which will affect imports to a certain extent and promote exports. At this time, the demand for foreign exchange will decrease and the supply of foreign exchange will increase, which will inevitably lead to a decline in the foreign exchange rate and an increase in the local currency exchange rate.

What is the relationship between foreign exchange rates and interest rates
On the contrary, it is not difficult to understand that when interest rates fall, it will lead to the expansion of credit and the bank’s money supply will increase, thereby further stimulating investment and consumption. Promote price increases, then exports will be affected at this time, which will benefit imports. In this case, the demand for foreign exchange will increase, which will cause the foreign exchange rate to rise and the local currency exchange rate to fall. The drop in real interest rates will cause the foreign exchange rate to rise and the exchange rate of the local currency will fall.

The effect of changes in foreign exchange rates on interest rates is actually an indirect effect. Foreign exchange rates affect a country’s price level, thereby affecting short-term capital flows and indirectly affecting interest rates. In addition, when a country’s currency exchange rate declines, psychological factors often make traders expect the country’s currency exchange rate to fall further. Then, under the background of the expected depreciation of the domestic currency, it will cause short-term investment capital flight and the reduction of domestic capital supply, which will promote the rise of domestic currency interest rates.

What is the impact of interest rate changes on exchange rates?

First, the interest rate policy affects the exchange rate by affecting the current account. When interest rates rise, credit tightens, loans decrease, investment and consumption decrease, and prices drop. To a certain extent, imports are inhibited, exports are promoted, foreign exchange demand is reduced, foreign exchange supply is increased, and the foreign exchange rate falls and the domestic currency exchange rate rises. Contrary to the rise in interest rates, when interest rates fall, credit expands and money supply (M2) increases, which stimulates investment and consumption, and promotes price increases, which is not conducive to exports and is conducive to imports. In this case, the demand for foreign exchange will increase, which will cause the foreign exchange rate to rise and the local currency exchange rate to fall.

What is the effect of interest rate changes on exchange rates
Let’s take the reduction of the RMB interest rate as an example to illustrate the conduction effect of the interest rate-exchange rate mechanism: interest rates fall, domestic demand rises, and import demand also rises, leading to a decline in the RMB exchange rate; rising import demand and rising inflation increase expectations for RMB depreciation. Enterprise imports increased while exports decreased, and capital outflows increased, leading to a decline in the RMB exchange rate. The drop in real interest rates has caused the foreign exchange rate to rise and the RMB exchange rate to fall. In fact, the effect of the decline in the RMB exchange rate is expansive: on the one hand, the decline in the RMB exchange rate, under the influence of changes in foreign relative prices, due to the expansion of exports, multiplied the national income, on the other hand, The decline in the RMB exchange rate has led to a decline in domestic demand through income redistribution effects and asset effects; at the same time, the profits of export companies have increased and the cost of imported goods has risen, which has pushed up the general price level. In short, the lower RMB interest rate has caused a decline in the RMB exchange rate, and its impact on aggregate demand is twofold.

Second, it indirectly affects the exchange rate by influencing international capital flows. When a country’s interest rate rises, it will attract international capital inflows, thereby increasing the demand for domestic currency and the supply of foreign exchange, causing the domestic currency exchange rate to rise and the foreign exchange rate to fall. Moreover, the increase in a country’s interest rate promotes an increase in international capital inflows, while a decrease in capital outflows reduces the balance of payments deficit and supports the increase in the domestic currency exchange rate. Contrary to the rise in interest rates, when interest rates fall, it may cause international capital outflows, increase the demand for foreign exchange, reduce the balance of payments surplus, and promote the increase in foreign exchange rates and the decline in domestic currency exchange rates.

The impact of exchange rate changes on interest rates

The impact of exchange rate changes on interest rates is also indirect, that is, through influencing domestic price levels and short-term capital flows.

First of all, when a country’s currency exchange rate drops, it is conducive to promoting exports and restricting imports. The cost of imported goods rises, which promotes an increase in the general price level, causing a rise in domestic price levels, which leads to a fall in real interest rates. This situation is conducive to debtors but not conducive to creditors, resulting in an imbalance between the supply and demand of borrowed capital and ultimately leading to an increase in nominal interest rates. If the exchange rate of a country’s currency rises, the impact on interest rates is just the opposite of the above situation.
The impact of exchange rate changes on interest rates

Secondly, when a country’s currency exchange rate drops, psychological factors often make people expect that the country’s currency exchange rate will fall further. Under the anticipation of the currency’s depreciation, it will cause short-term capital flight and the reduction of domestic capital supply will promote The rise in local currency interest rates. If the exchange rate of the local currency falls, people are expecting that the exchange rate will rebound. Under this circumstance, there may be changes contrary to the above-mentioned situation, that is, the increase in short-term capital inflows will increase the supply of domestic funds, resulting in a decline in local currency interest rates.

If a country’s currency exchange rate declines, the country’s terms of trade can be improved, as the terms of trade improve, the country’s foreign exchange reserves will increase. Assuming that other conditions remain unchanged, an increase in foreign exchange reserves means an increase in the supply of domestic funds, and an increase in the supply of funds will lead to a decrease in interest rates. On the contrary, if a country’s currency exchange rate rises will result in a reduction in the country’s foreign exchange reserves, it may lead to a reduction in domestic capital supply, and the reduction in capital supply will affect interest rates and increase it.

Transmission mechanism of monetary policy and exchange rate policy

From the perspective of my country’s situation, the interest rate-exchange rate transmission mechanism indirectly affects the effect of monetary policy through the domestic economy. The main content of this transmission mechanism is: various monetary policy tools, mainly interest rates, indirectly affect the exchange rate through the domestic economy. Changes in exchange rates in turn affect domestic financial operations and economic activities, thereby affecting the effects of domestic monetary policy. However, since my country’s market economic system is still in the process of reform, and the domestic economic environment is not perfect, the conditions for my country’s interest rate-exchange rate transmission mechanism to work are still immature. Although my country has joined the World Trade Organization, my country’s current capital account has not yet been fully opened and is still subject to strict controls. The foreign exchange market is still largely closed. The foreign exchange position market is limited to foreign exchange transactions between banks, and the domestic currency market is underdeveloped. The direct connection between the currency market and the foreign exchange market has not really been established. Therefore, as an important monetary policy tool, interest rates cannot affect the exchange rate through trade and domestic and foreign capital flows, but can only affect the exchange rate through indirect methods that affect the domestic economy. Conversely, changes in the exchange rate will cause corresponding changes in the balance of payments and domestic production. These changes will in turn affect the financial sector, thereby affecting the effects of monetary policy.

Monetary Policy

Some people may ask, does the decline in the RMB exchange rate mean that the RMB will appreciate or depreciate? Many friends want to laugh when they see this question, thinking it is simple, but in fact, it is such a simple question, and many people are confused.

As I mentioned above, the decline in the RMB exchange rate indicates that fewer U.S. dollars are exchanged for the same RMB and the RMB has depreciated.

Second, international capital flows have an impact on the exchange rate.

Rising interest rates attract domestic capital inflows, thereby increasing the demand for domestic currency and the supply of foreign exchange, causing the domestic currency exchange rate to rise (currency appreciation) and the foreign exchange rate to fall.

Seeing this, some people may ask, is there a contradiction between the two that the increase in interest rates will reduce investment while attracting the inflow of domestic capital?

Because the inflow of domestic capital should also come to invest, why is it said that investment demand will decrease? In fact, there is no conflict between the two, let me elaborate slowly. With the increase in domestic interest rates, it means that the cost of domestic investment projects has increased. This should be easy to understand. Naturally, no one is willing to invest in some projects with low investment returns, which will reduce investment demand. With the increase in interest rates, domestic capital is attracted to return. Why? Because when you have a lot of foreign currencies in your hand, and you see that your country’s currency is appreciating, you naturally choose to sell the foreign currency in your hand to exchange for RMB. But at this time, due to the decrease in domestic investment demand, a lot of this kind of capital will choose to buy domestic treasury bonds. After all, that is a risk-free return, and with the increase in interest rates, the yield of treasury bonds is also increasing, as well as some bank wealth management products.