Foreign Exchange Rates for Dollars

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Exchange rates for us dollars

We’re all aware that foreign exchange rates for dollars fluctuate, indeed all foreign exchange rates fluctuate. The changes in international exchange rates are caused primarily by local interest rates, to understand how interest rates affect foreign exchange rates for dollars, and other currencies it is necessary to understand what a foreign exchange rate is

The foreign exchange rate is determined by its relationship with another currency, it’s always a combination of two currencies, let’s take as an example the relationship between US dollars and Australian. Changes in domestic interest rates in one of the countries affect the foreign exchange rate as the demand for the currency that has had a change of interest rate will change.

If interest rates in the US 2% and interest rates in Australia are 5%. If there was an increase in US interest rates by 0.25 basis points this would then take the official rate to 2.25%.

So if there was a rise in interest rates in the US but in Australia interest rates remain constant then Australian dollars become a less attractive investment for investors. The increased rates in the US would entice people to move their investments (e.g. shares, property or other currency holdings) to hold US currency, because they would get paid a higher interest rate following the change.

This is because even a small change in consumer behaviour will cause an increase in demand for the US dollars and will lead to an increase in the foreign exchange rates for dollars.

Of course,  if the opposite were to happen, were interest rates in the US reduced by 0.25 basis points to 1.75%, then the demand for the US dollars would decrease as investors move out of holding US dollars and into other investments (shares, property or other currencies). A decrease in the demand for US dollars would then lead to a fall in all foreign exchange rates for dollars.

An increase in a domestic interest rate, holding all else constant, will increase demand for that country’s currency causing an appreciation of any exchange rates where the currency that has had the increase in demand is listed first.

A decrease in a domestic interest rate, holding all else constant, will decrease demand for that country’s currency causing a depreciation of any exchange rates where the currency that has had the decrease in demand is listed first.

 

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