Interest rates affect exchange rates because they directly affect the supply and demand of a country’s currency. Interest rates fluctuate directly affect the value of a currency. Higher interest rates give lenders higher returns relative to other countries; Higher returns attract foreign capital, which increases demand and causes the exchange rate to rise. The converse is true for lowering interest rates, which proportionally reduces the exchange rate.
The country’s central bank exerts influence on the exchange rate by setting interest rates and then controlling monetary policy. The main influence driving the exchange rate is the change in interest rates made by one of the eight global central banks. These banks increase interest rates to curb inflation and cut interest rates to promote loans and inject money into their economies.
An unexpected increase in interest rates in the United States relative to abroad will give investors a higher return on US assets relative to their foreign equivalents. This increases the value of the dollar, reduces import prices and reduces demand for US goods and services abroad.
The relative exchange rates because they are the ratio of currencies of two countries. Several factors determine the exchange rate, but all are related to the economy and trade relations between the two countries. Interest rates provide a scale for loan costs or profits from loans.