Effect of Interest Rate on Foreign Exchange Rate

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EFFECT OF INTEREST RATE ON FOREIGHN EXCHANGE RATE

(EVIDENCE FROM ASIAN REGION)

ABSTRACT:

In this article we investigate the impact of a change in U.S. short term interest rates relative to those in some Asian countries like Bangladesh, Thailand, Japan, Pakistan, and China on the bilateral foreign exchange rates between the U.S dollar and each country’s currency. Several factors determine the exchange rate of a country. A higher currency makes a country's exports more expensive and imports cheaper in foreign markets; a lower currency makes a country's exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can be expected to lower the country's balance of trade, while a lower exchange rate would increase it. In this paper we show both theoretically and empirically that the relationship between nominal interest rates and the nominal exchange rate is inherently non-monotonic i.e., sometimes it is positively related and sometimes it is negatively related. By analyzing the relationship between interest rate and foreign exchange rate we find that interest rate has a significant effect on foreign exchange rate.

INTRODUCTION:

With the foreign exchange value of the U.S. dollar continuing to increase rapidly, the search goes on for explanations of this unprecedented rise. Explanations of exchange rate movements frequently focus on two factors: (1) change in credit market conditions reflected by changes in interest rate differentials across countries and (2) changes in the monetary policy stances of central banks especially those of the Federal Reserve.

The Exchange Rate is simply the price of one country’s currency in terms of another’s. It is determined in organized, efficient markets in the same manner as are the prices of other assets, such as stocks, bonds or real estate. Because these assets are durable, their current prices reflect people’s perceptions of current events and expectations of future events as well. In other words, the current price of the asset reflects its expected future price. Consequently, any information that leads individuals to their expectations about the future price of an asset has an effect on the asset’s current price.

The assets involved in the determination of exchange rates are domestic money supplies. Thus, the fundamental determinants of exchange rate movements must include, among other things, the factors that affect the demand for and the supply of domestic moneys. Obviously then, the monetary policy objectives of central banks, the market’s perception of the future course of policy actions, and credit market conduit.

Exchange rates play a vital role in a country's level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are among the mostly watched, analyzed and governmentally manipulated economic measures. Before we look at those forces, we should sketch out how exchange rate movements affect a nation's trading relationships with other nations. A higher currency makes a country's exports more expensive and imports cheaper in foreign markets; a lower currency makes a country's exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can be expected to lower the country's balance of trade, while a lower exchange rate would increase.

Exchange rate:

In finance, an exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency. For example, an interbank exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (US$) means that ¥91 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥91. Exchange rates are determined in the foreign exchange market,[2] which is open to a wide range of different types of buyers and sellers....
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