Noob question: How do interest rates affect currency rates?

If possible, could you relate it with inflation rate as well.

ps. my reading comprehension on fundamentals are horrible! Keep it simple please!!

http://www.babypips.com/school/interest-rates-101.html

Ok interest rates make the world go round. Put simply if Bank A is offering 2% interest p/annum and Bank B is offering 3%, provided all the fees are the same, where would you put your money. Likewise for the worlds economies (although other economic factors are weighted not just interest rates). So Australia has 4.75% and GBP is .5%. This helps explain, along with other factors, why the GBP/AUD has been in a steady decline.

Inflation is basically a measure for the increase or decrease of general goods. If your shopping cost you overall $100 and there was a 3% increase in inflation then overall the general cost for your next shop would be $103. Deflation should work in reverse but is not always the case as prices tend to fall slower than they rise in everyday goods. This is tied in with world demands and the import/exports of each country in question.

High inflation can lead to overspending which needs to be curbed and one way is to increase interest rates which has effects on overall mortgages, personal loans and credit cards which helps to minimise the spending and increase saving attitudes due to higher interest returns at your bank. Too much inflation can lead to runaway prices and market bubbles that eventually bust.

Deflation requires stimulating and lower interest rates helps to urge people to borrow money again to purchase goods which helps to bolster the economy. People can also use the money they saved in there long term deposits to buy goods at generally lower prices as they are not making as much money holding it which also stimulates the economy.

There are far more factors that go into it and both are not good in excess. Excess inflation drives prices far to high for low to medium income earners making living a nightmare week to week and excess deflation usually means cost cutting in business which leads to higher unemployment which is just as if not more difficult to come out of which is why interest rates are a prime market mover. However fundamentally a country or group of countries needs to be taken into account in respect to the country or group of countries that you are trading with or against.

RT

Thanks! However there is one thing I don't get. Say when we deposit money into the bank, with high interest rates, we get more interest over time right?
Wouldn't that make the demand for the currency increase? Since its a good place to grow your money in the bank.

And higher interest rates slows down the economy and depreciates the currency.

What does interest rate refer to? When we deposit money or when we borrow money?

The currency with a higher interest rate will usually be the stronger currency. The carry trade tries takes advantage of this situation. The AUD is a current example. What the carry trader will do is go long a currency with a high interest rate at the same time longing another currency that is strongly negatively correlated. So the carry trader will go long the AUD/USD and the USD/CHF. In theory these two positions will hedge each other and the profits will come in the form of interest payments. Here is a link to current interest rates.

http://www.fxstreet.com/fundamental/...t-rates-table/


These are just the basics. I took a month long online class a couple years ago on carry trading but never really put it into practice so my knowledge may not be the most accurate.

As far as inflation goes, I personally believe that inflation is directly correlated with total amount of money in the system i.e. the more money available, the less it will be worth. The Fed is currently printing money as fast as they can get paper, a lot of people are worried that this will eventually lead to hyperinflation. In general a central bank is printing money and trying to keep the fed funds rate low in an attempt to stimulate the economy. When they want to slow the economy they do, or should do the opposite.

The interest rate is the fed funds rate. It is the amount that banks charge to borrow money from each other to ensure their reserve requirements are maintained. The prime lending rate is based on this rate, but is considerably higher and is usually the interest rate that banks charge for mortgage loans. The interest rate that you get in a bank savings account doesn't really have anything to do with the fed funds rate.

Thanks for all the help everyone! Got a better understanding already.