Interest rates

Definition

Interest rates are the cost of borrowing money or the return on savings, expressed as a percentage of the principal amount over a specific period of time. They play a crucial role in the international monetary system as they influence exchange rates, investment decisions, and overall economic activity. Changes in interest rates can lead to shifts in currency values, affecting trade balances and capital flows between countries.

5 Must Know Facts For Your Next Test

1. Central banks use interest rates as a tool to regulate economic growth and control inflation by raising or lowering rates.
2. Higher interest rates typically lead to stronger currencies because they attract foreign investment seeking higher returns.
3. Conversely, lower interest rates can weaken a currency as they may lead to capital outflows in search of better yields elsewhere.
4. Interest rate differentials between countries can create incentives for investors to move capital, influencing exchange rate fluctuations.
5. In times of economic uncertainty, central banks may lower interest rates to stimulate borrowing and investment, supporting economic recovery.

Review Questions

• How do interest rates affect the exchange rate between two currencies?
  • Interest rates have a direct impact on exchange rates due to their influence on capital flows. When a country raises its interest rates, it often attracts foreign investors looking for higher returns, increasing demand for that currency. This demand can cause the currency to appreciate relative to others. On the other hand, lower interest rates may result in capital outflows as investors seek better yields elsewhere, leading to depreciation of the currency.
• Evaluate the role of central banks in manipulating interest rates and its implications for international business.
  • Central banks play a vital role in setting interest rates through their monetary policy decisions. By adjusting these rates, they influence borrowing costs and overall economic activity. For international businesses, changes in interest rates can alter investment strategies, affect pricing of goods and services, and modify competitive advantages based on exchange rate fluctuations. Thus, understanding central bank policies becomes essential for making informed decisions in global markets.
• Assess how changes in global interest rates could impact emerging markets and their economic stability.
  • Changes in global interest rates can significantly impact emerging markets by influencing foreign investment and capital flows. If global interest rates rise, these markets might experience capital flight as investors move funds to seek higher returns elsewhere, destabilizing their economies. Conversely, falling global interest rates could attract foreign investments into these markets but may also lead to increased borrowing and potential inflation. Balancing these dynamics is crucial for maintaining economic stability in emerging economies amid fluctuating global financial conditions.

Related terms

Exchange Rate: The price of one currency in terms of another, determining how much of one currency can be exchanged for another.

Monetary Policy: The actions undertaken by a country's central bank to control money supply and interest rates to achieve macroeconomic objectives.

Inflation Rate: The rate at which the general level of prices for goods and services is rising, eroding purchasing power.