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Have you ever wondered what effect a low interest rate potentially has on a currency? With the US Dollar and Japanese Yen at near zeros, this is an important concept to understand.

The various Central Banks have various policies regarding the monetary management of their countries. With this brings about the various interest rates. The interest rate difference between currency A and currency B is known as the interest rate differential.

The interest rate differential is one of the main primary mover of the currency exchange market. Investors, traders, speculators, businesses, etc have various use for this difference in interest rates.All other things being equal, a currency with a lower interest rate usually weakens against a currency with a higher interest rate. The greater the interest rate differential, the more likely the effects are seen.

Looking at the illustration above,

we see that the weaker currency A is sold in exchange for currency B. Applying basic supply and demand economic concepts, currency A is in supply thus weakening in price while currency B is in demand thus increasing in price.

Many basic facts of the global economy encourages this pattern.

Most businesses borrow from a country with lower interest rates to expand in other economies
Many investors shift their investing dollars to economies with higher yielding potentials
Carry trade traders sell currencies with lower interest rates in exchange for currencies with high interest rates to make use of the interest rate differential

Understanding the above sheds light on why interest rate hikes or reductions are often very closely monitored by the markets. The impact it creates is usually far reaching.

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How a low interest rate affects a currency

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