How Does Raising the Key Interest Rate Strengthen Currency?

The key interest rate (also known as the "prime rate") is the percentage that a central bank or monetary authority charges on loans to commercial banks. Raising this rate strengthens a nation's currency because it raises the returns on deposits in a given currency in relation to other currencies, as well as signaling growth in the economy and a decline in inflation.

Prime Rate

The prime rate of any country is controlled by a central bank or monetary authority. In the U.S., this authority is the Federal Reserve. A country's central bank is in charge of monetary policy, and one of its main tools is the prime rate. The Federal Reserve raises or lowers the prime rate to influence national savings, investment, employment, inflation and the exchange rate. The Federal Reserve usually operates on the basis of targets (for example, the target inflation rate is 2 percent).

Reasons to Raise

Raising or lowering the prime rate has specific effects on the economy. Raising the interest rate encourages savings, controls inflation and discourages borrowing and investment. The higher the interest rate, the more money you can make by simply saving (and if the population spends less, inflation proceeds at a slower rate), and the more expensive borrowing becomes. While all of these factors affect the exchange rate in different ways, it's the savings mechanism that immediately strengthens a currency.

Returns

Raising the prime rate raises the returns (the amount paid in interest) on deposits in that currency. When people can make more money with accounts in one currency as opposed to another, they will buy the more lucrative currency until the exchange rate adjusts to the demand. The exchange rate adjusts almost instantly since both buyers and sellers around the world are aware of what is going on, and buyers will immediately start buying while sellers will immediately start raising their prices.

Example

Assume that the euro and the dollar are at parity (one dollar buys one euro and vice versa), and both the E.U. and U.S. prime rates are at 3 percent with annual inflation at 2 percent. If the Federal Reserve raises the prime rate from 3 percent to 3.25 percent, and all else remains constant, deposits in dollars become 25 percent more lucrative than deposits in euros at that exchange rate. As soon as this happens, anyone involved in currency trading will switch their euros to dollars; however, this activity (high demand for dollars, low demand for euros) immediately pushes up the exchange rate because those selling dollars will start asking for more.

Other Signals

Raising the prime rate sends out a number of signals about a nation's economy. Raising the interest rate often signals strong economic growth, to the point where the central bank can make a move that discourages investment and raises the exchange rate (which makes exports less competitive). Raising the interest rate also lowers inflation and can show that the central bank is interested in controlling inflation, which often reassures investors.