Question

Consider and describe how interest rates and exchange rates impact foreign direct investment and foreign exchange money flows. Comment on PEG, Free Floating System, etc.

Answer 1

All other factors being equal, higher interest rates in a country increase the value of that country's currency relative to nations offering lower interest rates. However, such simple straight-line calculations rarely exist in foreign exchange. Although interest rates can be a major factor influencing currency value and exchange rates, the final determination of a currency's exchange rate with other currencies is the result of a number of interrelated elements that reflect the overall financial condition of a country in respect to other nations.

Generally, higher interest rates increase the value of a country's currency. Higher interest rates tend to attract foreign investment, increasing the demand for and value of the home country's currency. Conversely, lower interest rates tend to be unattractive for foreign investment and decrease the currency's relative value.

Free Floating System

A system where exchange rates are determined entirely by the markets. Governments may attempt to increase or decrease the value of a currency by using monetary and fiscal policies, but in this system, they do not directly interfere with the value of a currency. For example, the value of the US dollar is driven entirely by market factors such as supply and demand, though the Federal Reserve controls the money supply and can increase or decrease their spending.