Recently, everybody has been talking about interest rates, and it’s not surprising. The bank of England has increased the interest rate from 1.75% to 2.25%, making a huge impact on the cost of mortgages just about every other aspect of payments in the UK. Higher interest rates also affect another area of the economy too, and that’s currencies. So, keep reading and discover how interest rates effect exchange rates and determine a currency’s value. 

What Is An Interest Rate?

If you’ve ever borrowed money, then you’ll most likely be aware of an interest rate. Strictly speaking, an interest rate determines how much money a lender is going to charge a borrower on top of what they borrow. So, if you were to borrow £100 and the interest rate is 2.25%, then you’ll pay back £102.25 in total. Interest is applied to all sorts of things like overdrafts, credit cards, and mortgages. This easily shows you how many different things are impacted when the interest rate is increased. You’ll typically see the interest rate listed as a %APR which means annual percentage rate. This is the yearly interest rate on a borrowed amount and helps to ensure that you aren’t repaying too much to the lender. 

Why Do They Increase?

Increasing the interest rates is a method of managing the economy because it can dissuade people from borrowing as much money. This then lowers the demand and allows the economy to expand at a steady rate and keep it stable. Inflation is also a number one reason why interest rates are increased too. So, generally, if inflation is high, interest rates are high. 

What Happens To Currency When They Increase?

Typically, when interest rates increase, the currency value will increase too and vice versa. For instance, the pound’s exchange rate is set by the investors trading all the different sums of currency. Then when the interest rates go up, demonstrating a sign of an expanding economy, the pound becomes a lot more sought after. Investors will then buy more pounds, strengthening the currency and increase it’s value alongside the interest rates. 

What Happens When Other Banks Increase Their Interest Rates?

Not all interest rate increases are good for currency. For example, if the European Central Bank increased their interest rates, then the pound can lose a lot of strength against other currencies. Especially if the interest rate is higher than that of the Bank of England. It forces the pound into a weaker position when up against other strong currencies like the euro. So, while it may be good when your own central bank increases interest rates, it’s not so good when other central banks increase theirs. 

Interest rates impact a lot of different areas of the economy, but they definitely do have a big effect on currency. Higher interest rates will typically mean a stronger currency for the country, but it’s not always the case. Lowering the interest rates will normally have the opposite effect too and weaken a currency. This is why central banks are quite opposed to decreasing interest rates, especially if they want to help grow the economy. So, it’s easy to see why higher interest rates impact a currency’s value, and we’ll hopefully see this happen for the pound some time soon!