In: Finance
What is the relationship between currency values or exchange rates (both spot and forward), interest rate differentials between countries, and inflation rate differentials between countries? If possible, use a diagram to explain how these various measures are related and/or impact each other.
A currency value is determined by the exchange rate with other currency mainly US Dollar.
There are various factors by which it can be affected.
Interest rates affect the rate very much as a country has a low-interest rate then the value of the currency will be low and if a country have high-interest rate then the value of the currency will be high. To explain this let us take a country with a high-interest rate than other countries then investors will try to put their money in the banks of that country to get more interest so they will demand the currency of that country and as the demand increases the exchange rates of the currency increases. And opposite with country of low-interest rates, no one will invest in the banks of that country and investors of that country will also invest in other countries having more rates than that country, this will create a supply of the currency of that country making the exchange rates low.
Inflation plays an important role in deciding exchange rates, High inflation rate has a bad impact on the currency of the country. As inflation rises the purchasing power (a fixed amount of money) decreases, as people can buy the commodities with the same amount. Same work with the exchange rates if inflation rises the value of currency decreases as the currency can not but the same number or amount of commodities it can buy before.