There are several different monetary models that try to explain why the forex market moves. One such model is the real interest rate differential model.

The real interest rate differential theory states that exchange rate movements are determined by a nation’s interest rate level. Countries that have high interest rates should see their currencies appreciate in value, while countries with low interest rates should see their currencies depreciate in value.



Once a nation raises its interest rates international investors will discover that the yield for that nation’s currency is more attractive and will therefore buy that nation’s currency fully expecting it to appreciate.

This model also stresses that one of the key factors in determining the severity of an exchange rate’s response to a shift in interest rates is the expected persistence of that shift. Simply put, a rise in interest rates that is expected to last for five years will have a much larger impact on the exchange rate than if that rise were expected to last for only one year.

There is a great deal of debate among international economists over whether there is a strong and significant link between changes in a nation’s interest rate and currency price. The main weakness of this model is that it does not take into account a nation’s current account balance, relaying on capital glows instead. Indeed, the model tends to overemphasize capital flows at the expense of numerous other factors. Absent these factors, the model can be very useful since it is quite logical to conclude that an investor will naturally gravitate toward the investment vehicle that pays a higher reward.

Author: Christopher M. Hall
Article Source: EzineArticles.com
Provided by: Creditcard Currency Conversion Fee

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