In economic theory, if the interest rates in one country increase, then the currency value of that country will increase as a reaction. If the interest rates decrease, then the opposite effect of depreciating currency value will take place. Thus, the central bank of a country might increase interest rates in order to “defend” the local currency by causing it to appreciate in value in respect to foreign currencies.
In order for the changes in domestic interest rates to affect the value of domestic currency, we have to assume that the economy is open, has a floating exchange rate, and that the investments are relatively risk-free.
Open and closed economies
An open economy allows purchase of goods and transfer of funds to take place between different countries. A closed economy, on the other hand, restricts foreign investments and international trade.
Fixed exchange rate
A country has a fixed exchange rate system if the value of a country’s currency relative to other currencies changes only when policy makers bring about the change. The currency’s value may be reduced, for example, in order to make its products cheaper in foreign countries and thereby increase its exports. This is because the reduction in value of the domestic currency will make it cheaper relative to foreign currencies.
Floating exchange rate
In a country with a floating exchange rate, the value of the currency changes in response to market conditions. Most industrialized countries have a floating rate system after switching from the Gold standard in 1973 where the value of currencies was fixed in terms of gold.
Currency appreciation and depreciation
The value of currency increases if there is an increased demand for it, and decreases if demand has fallen. Increased interest rates for a particular country attract foreign investors due to the increased rate of return from investments. This causes an increase in demand for domestic currency in order to purchase the investments, causing the currency to appreciate in value.