How Interest Rates Affect Currency

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The prevailing rate of interest at which lenders are willing to loan borrowers money depends on a number of factors. For example, if an economy is booming, interest rates will likely rise because more people are seeking loans to expand businesses and purchase goods. Interestingly, interest rates are both affected by and, in turn, exert an effect on the value of the currency in which the loans are being issued.

Interest Rates

  • While the interest rate that an individual can receive on a personal loan will have a lot to do with his own credit history and rating, the rates available to borrowers in aggregate will depend in large measure on macroeconomic trends. As rates go up and down, this will affect the value of the currency in which these loans are made by affecting the supply and demand of this currency.

Value of Currency

  • Money constantly gains and loses value. Although it might seem absurd that a unit of currency does not have a consistent value -- a dollar is a dollar, right? -- the quantity of goods and services that this currency can buy will depend in large part on the supply and demand of the currency as well as the price for the goods and services that are being bought and sold in this currency.

Supply and Demand

  • As interest rates go up, the supply of a particular currency will go down because less of the currency will be available at a low price. Conversely, as interest rates fall, the value of the currency will also trend down because the currency is easier to get. In effect, interest rates help determine how valuable money will be in the future because they state how much a person will have to repay in the future for borrowing money now.

Monetary Policy

  • In many countries, interest rates are set in large part by the actions of the country's central bank, which controls the amount of currency in the economy. In the United States, the Federal Reserve helps control interest rates by taking money into and out of circulation. When it wishes to lower interest rates, the Fed will issue more money, thereby both making the currency less valuable and making it easier to come by, leading to lower interest rates.

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