Why Lower Interest Rates Result in Appreciation of the Currency

In simple terms, lower domestic interest rates depreciate the currency. Economic life, however, is never so simple. Low rates can, for specific reasons, appreciate the currency -- that is, cause it to increase in value. This is the case both for domestic and foreign interest rates. The point is that anything causing the U.S. economy to boom will make dollars more in demand, thereby increasing its value.

In general, lower interest rates lead to an exodus from the bond market. This is because that market is dependent on higher rates, because higher rates on bonds mean greater profits later. Stocks seem more attractive when domestic rates fall. Speaking in general terms, an exodus from the bond market might make money more difficult to raise, appreciating the dollar's value in the long run.

Low rates often accompany economic good times. Low rates mean money is cheap, and businesses begin to borrow, risk more and spur innovation. People buy more, because credit is cheaper. That increased spending because of low rates lowers the savings rate. This, over time, increases the price of the dollar because liquidity becomes more scarce. Market watchers realize that high borrowing and spending resulting from low domestic rates means fewer dollars for tomorrow’s borrowing. High borrowing today means a more expensive dollar tomorrow.

Low foreign rates typically mean a stronger dollar. This is because money will leave foreign markets and come to American markets, increasing the demand for dollars, hence appreciating its value. Low foreign rates also take money out of the American economy, because these low rates make foreign goods cheaper than domestic goods. Dollars leaving the country means the remaining dollars are worth more.

The dollar is special in international markets, because it is connected with the economic, military and political power of the United States. The dollar often remains strong regardless of rates, because the dollar is considered a “safe bet” by investors. If interest rates remain low and economic activity in the U.S. booms, investors from abroad will continue to demand dollars, keeping its value high regardless of domestic rates.The dollar conceivably could get stronger as rates fall, because foreign money wants a dollar connected to a booming economy. As the American economy moves forward, foreign money demands dollars, and the dollar remains strong. Therefore, in this case, low rates can, over time, lead to an appreciated dollar.