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International Economics: The Relationship Between Interest Rate And Exchange Rate

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The relationship between the interest rate and exchange rate has long been a key focus of international economics. This also explains the theoretical and empirical literature proves that there exist a relationship between interest rate and exchange rate. Some studies found out that in the short run, there exit a negative relationship and positive relationship in the long run. Moreover, most papers and articles in countries deliberate on the impact of these economic variables (exchange rate and interest rate) in equally determining a country’s economic growth, inflation, levels of international trade and other economic determinants. In terms of dealing with the global markets (international trade), the link between these are realistic and of great concern. Mention in Madura, 2008 under his article on the theory of “International Finance” sites relevant factors the influence exchange alongside interest rate. These includes: changes in inflation; changes in interest rate; changes in relative income and expectation on future exchange rate.
1. Changes in Inflation. …show more content…

A high inflation will depreciate the domestic currency and an increase in inflation will increase the demand for foreign goods. It also decrease export, leading to balance of payment deficit. Hence, exchange rate on the foreign base countries currency will rise which appreciate the home base currency, (Madura, 2008). He also explained the relationship using the purchasing power parity. The theory of PPP states that a basket of a good in one country should have the same cost in another country, taking into account exchange

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