The Relationship between the Exchange Rate and the Interest Rate
- If the UK’s exchange rate rises, export prices in terms of foreign currencies will rise
- Demand for exports will therefore fall, reducing AD
- This lower AD will reduce inflationary pressure
- This lower inflationary pressure could mean that the MPC will reduce the interest rate.
- A reduction in the UK’s interest rate is likely to reduce the exchange rate
- This is because a lower interest rate will reduce the return on money kept in UK financial institutions
- This is likely to cause an outflow of funds to other countries, to take advantage of higher interest rates
- This will mean more of the currency is being sold, and this increased supply will lower the exchange rate.
- This relationship is not always true though.
- A cut in the rate of interest in the UK could make foreigners more confident about the prospect of UK economic growth
- They will then want to put money in UK financial institutions, increasing the demand and increasing the exchange rate.