Factors Influencing Interest and Exchange Rates

There is no denying that economic activities are, to a great extent, determined by the financial industry. Hence, money can be seen as the main aspect of economic growth and sustainable development. During the 2007/2008 Great Depression, the world was hit by one of the worst economic failures, where some markets totally failed while others came to the brink of collapse. But what may be interesting is that this situation was caused by a collapse in the financial industry, which begun from a significant devaluation of houses and certain assets. Financial institutions have used these assets are collateral while lending money to borrowers. When the markets failed, it becomes very difficult for them to recover what they had given out fully. It hit worse because they had no take into account proper assessment and the ability of the borrowers to repay the loans.

In the business cycle, recessions may come as the worst time for certain sectors. It is only those who are well knowledgeable and prepared for the situation that can survive. Governments may quickly step in with monetary policies that shield not only the producers but also the consumer of such services. And one way to do this is by reviewing interest rates. Many will still need money to run their businesses efficiently, which may come from financiers.

On the other hand, there are exchange rates that determine the cost of price for international goods and the risk of doing business in another country. Nations that value their currency too high seem to chase away investors, if their economy is not stable. And it is the same fate for those who have their currency too cheap. Economic activities of a country determine the strength of their currency.

Exchange rates and interest rates are two economic aspects that walk hand in hand. This is why most banks deal with exchanges, and of course, interest rates as lenders. It is, therefore, important to understand the factors that affect both interest rates and exchange rates.

Interest rates

Financial institutions benefit from interest rates, which is the cost of borrowing money. Look at it like buying a piece of cloth that costs $25. In this case, perhaps the cost of production is $20, the cost of marketing is $1, and the profit is $3. If this is the retail price, perhaps the profit to the manufacturer is $2. This is the same case with 'buying money.' It is what you pay for the money, from which the financier gets their profit. This means, on one side, it is the expense on the consumer's side, while on the other side of the coin, it is the compensation for the service and risk of lending money.

And if you are a borrower, a lender, or both, understanding the reasons for changes in interest rates will help make more informed decisions. Note that these changes don't just affect money buying; it extends to rare metal trade, including silver stocks, and many other sectors.

Lenders vs. Borrowers

To give out money, the lender takes the risk that the borrower may not be able to pay back the loan. For this reason, the interest rate stands as a certain compensation shielding them from the risk. Apart from the default, there is also the risk of inflation, which may cause a devaluation in assets used as security for a loan. A financier may lend money now, and then the price of goods and service surge by the time they are paid back. In this case, the resource's original purchasing power would have reduced. Hence, the interest rate also protects the lender against such. Also, a lender, just like a bank, uses the interest to process the costs while keeping a borrower's account open.

Borrowers on the, on the other hand, pay the money because they gain the privilege of spending money, they would have spent years saving for now. For instance, a family may be looking for a house, which they may not be able to pay for at the moment; in this case, a mortgage loan may encourage them to become homeowners much faster, instead of having to wait years for the opportunity.

Businesses borrow too because they are looking for future profits. They use the money now too, but equipment and invest in other items so that they can start earning revenues. Banks also borrow to increase their lending activities, where the consumption rate is above what they currently have.

Hence, we can look at the interest rate as the cost one entity has to pay for the income of another. It comes also be seen in terms of lost opportunity, or opportunity cost, for keeping one's money under a matter in relation to lending it. The interest rate may be lower than the cost of sacrificing to use the money now, which is why many people would prefer borrowing and spending now rather than saving for a year and losing on the current opportunities.

What determines Interest rates?

Financiers, unless they are just family and friends, cannot just wake up and create interest rates without looking at underlying factors. In this case, the following are factors that determine interest rates.

Supply and Demand

Just like many other goods and services, which pricing depends on supply and demand, borrowers also look at how many people are looking for credit and it available. If there is an increase in demand, the lender will probably increase the interest rate, not only for the profit but to control the process. And demand is low; banks will want to incentivize borrowers by offering them lower interest rates. Conversely, when there is an increase in supply, the interest rate goes down because consumers have more options, whereas less supply leads to a surge in interests.

In other words, where there is a lot of money to give to borrowers, supply goes up. For instance, you can lend money to a bank by opening an account with them. The bank will use the money for their business activities, which earns you interest(depending on the type of account to open; a certificate of deposit comes with a higher interest than a checking account, which lets you check your money any time). The bank can, for instance, lend out the money to other consumers to increase their network. As a result, there is more credit available for the benefit of an economy. And when borrower defers loan repayment, there is a decrease in economic credit. This means that when you postpone paying for one moment, you will be increasing the interest you have to pay and reduce the amount of credit in the general market, which leads to harder interest rates in the economy.

Inflation

We cannot live without inflation. This is an aspect of economic growth and development caused and influenced by different factors. When there a rate of inflation, then interests rates will also rise because the lender needs to shield their investments against such risks. The lender will demand higher compensation since there purchase power for money will have reduced, which makes them require higher amounts of compensation.

Government intervention

During the Great Recession, both the lower and the upper houses sat to draft monetary policies that curbed investors and borrowers alike. One of the measures was to reduce interest rates so that borrowers can easily access capital for their businesses. Governments have a say in the scope of interest rates. For instance, the U.S. Federal Reserve is in charge of reporting how monetary policies would impact producers and consumers.

The federal funds rate, or what institutions charge each other for short-term loans, affect the interest rate banks set for lending the money. The same rate flows down into other short-run rates for lending. These rates are regulated by the Fed, by means of "open market transaction," a process that involves buying or selling of previously issues security in the U.S. market. 

Sometimes the government may buy these securities, in which case they inject banks with money to lend by decreased rates. When it sells, the banks are drained, leaving them with fewer funds for lending, hence increasing interest rates.

Laon types

Supply and demand are the major forces influencing interest rates. There are many types of loans, which comes with different rates depending on the credit risk, time, tax considerations, and loan convertibility. Risk is the likelihood of the loan being repaid, in which case, higher risks leads to higher interests. When the loan is "secured," with some collateral, the lender may take possession of the property as compensation, in which case, interest rates are lower. Government-issued debt securities come with minimal risks because the borrower is the government. For this reason, treasure securities tend to much lower because there is no tax on the interest rates. The issue of time also affects loan interests. Longer-term loans are more flexible but come with greater changes of not being repaid. This is echoed by potential inflations that affect the mode of business for the lender; hence, the longer the borrower has to pay, the more interest they have to deal with.

Exchange rates

Every nation strives to build a good relationship with another, in which case, exchange rate movements impact the nation's trade ties with others. A currency value is, therefore, a critical aspect of economic growth, whereby high-valued currents mean the country's imports are less expensive in foreign markets. The lower-value currency, on the other hand, raises a country's import price on foreign markets. In either case, a higher exchange rate can make it hard for a country to balance trade, whereas lowered rates are expected to improve it.

There are a number of factors that influence exchange rates. Many of the factors have a direct link with the relationship between the countries involved. Note that the exchange rate is relative, and expressed as a comparison of two currencies. Hence, you can expect these rates to follow specific trends and be impacted by various factors.

Differences in inflation rates and interest rates

As stated above, when looking at exchange rates, we have to consider two countries. And since inflation varies between the countries, you can expect there to be varying differences in exchange rates as well. A country that exhibits lower inflations also experiences higher values for their currency because they have higher purchasing power. Countries like Japan, German, and Switzerland showed the lowest inflation rates during the last half of the 20th century, whereas the U.S. and Canada achieved It later. Countries with lower inflation witness depression in their currencies in comparison with their trading partners.

There is a major relation between interest rate, inflation, and exchange rate. Central bank exerts an impact on inflation and exchange rates when they manipulate interest rates. When interest rates change, there is a change in inflation and currency values. Higher interests attract and an increase in the exchange rate, as it attracts foreign capital. If there is more inflation, however, there is a need to mitigate interest rates. On the opposite, lower interest rates cause a decrease in exchange rates.

Current account deficits and public debt

The balance of trade between two or more countries is referred to as the current account. It reflects all payments between the partners for goods, services, and dividends. If there is a deficit, it means the country is spending more foreign trade than its earning, and it may be borrowing more to make up for this deficit. A country needs foreign currency, which comes from sales of export. If there is too much demand for foreign currency, the country achieves a live exchange rate and vice versa.

A country may use large-scale deficit financing to cater for projects by the government. Such projects can stimulate growth in the domestic economy, but the expense of foreign investments. A large public debt causes and increases in inflation, which reduces the country's currency value. And when things get worse, the government may print money to pay part of the debt, which increases inflation.

Other factors that affect the exchange rate include terms of trade and strong economic performance. As discussed above, the interest rate affects exchange rates, just like the exchange rates influences interest. In other words, these are terms of economic growth and development that cannot be ignored.

Author: James Hamilton