EFFECTS OF CHANGES IN INTEREST RATES ON THE VALUE OF A CURRENCY Firstly, Interest rate can be defined as a reward for saving OR a cost of borrowing. But in this case we will look at it as a reward for saving. Banks and other large financial institutions collectively have trillions of dollars worth of funds that they can move from one type of investment to another at very short notice. These funds are often called “hot money.” Suppose that the relative interest rate in the United States or any other country that do trade with for example Malawi suddenly rises. Then, U.S. assets will suddenly be more attractive to residents of both the United States and Malawi, including managers of hot-money accounts in both countries. As these managers shift their funds from Malawian to United States assets, they will be dumping billions of Kwachas on the foreign exchange market in order to acquire dollars to buy U.S. assets. This will cause a significant rightward shift of the supply of Kwachas curve. In addition to affecting managers of hot-money accounts, the higher relative interest rate in the United States will affect ordinary investors. Malawian investors will want to buy more American assets, helping to shift the supply of Kwachas curve further rightward. And American investors will want to buy fewer Malawian assets than before, causing some decrease in the demand for Kwachas. Thus, in addition to the very large rightward shift in the supply of Kwachas, there will be a more moderate leftward shift in the demand for Kwachas. In this case the Kwacha will depreciate while the U.S Dollar will appreciate.
Posted on: Fri, 26 Jul 2013 13:09:04 +0000