Interest Rate And Currency

Similar to how we learned the relationship between inflation and currency in the previous unit, we will now learn the relationship between interest rates and currency. So, without any further ado, let’s get started: 

In the short-run, the most important factor affecting an exchange rate is the interest rate. The relation between the exchange rate and interest rate is known as Interest rate parity (IRP).

IRP states that if the interest rate in one currency (say currency B) is less than the interest rate in another currency (say currency A), currency B should be at a forward premium to currency A. More specifically, currency B should be at a forward premium against currency A approximately to the extent of the interest rate differential.

Interest rate not only helps in determining the forward premium/discount of one currency against that of another but also helps in determining the movements in spot exchange rates through a phenomenon known as carry-over trade. A carry-over trade is when we buy a high-interest currency against a low-interest currency.

For example, if INR has a 5% interest rate and USD has a 2% interest rate, we buy INR/USD. We make a carryover trade.